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

In recent posts (here and here), I have discussed the issues surrounding coverage under D&O insurance policies for investigative costs and special litigation committee expenses. In response to these posts, readers Jeff Kiburtz and Cindy Forman of the Santa Monica law firm of Shapiro Rodarte & Forman have submitted the following guest blog post. This guest post of course reflects the views of the post’s authors, and not necessarily those of the author of The D&O Diary. Cindy and Jeff's guest post is as follows:  

Having recently ended an unusual week straight of rain in normally sunny Los Angeles, the saying "when it rains it pours" comes to mind. This phrase aptly describes the situation in which many companies find themselves when revelations of accounting irregularities or other alleged misconduct surface – first there is a story in the press, then a letter indicating the SEC opened an informal investigation, next a DOJ subpoena, and, sometime during this period, the company’s stock drops and a shareholder makes a demand for an investigation or forgoes the demand and files a derivative suit.

The response to this downpour is immediate and expensive. Typically, at least three sets of law firms are retained – one to handle the government investigations and private litigation, a second to conduct an internal investigation and report to a special committee established by the company, and a third, which usually consists of several different firms, to defend the implicated directors and officers.

Recognizing the potential to spend large amounts of money very quickly, in-house counsel and the company’s outside lawyers move to create a division of labor between the various firms to coordinate the overall effort. Central projects such as the review, coding and scanning for privilege of all of the documents potentially relevant to the underlying issue are assigned to a specific firm, frequently the internal investigation counsel. Work specific or unique to the various groups is, however, done by the respective group’s own counsel.

Although each firm represents the unique interests of their clients, and potential or actual conflicts are therefore implicit, in many circumstances the various interests are largely aligned and the attorneys can and do work together for the mutual benefit of all. If, for example, the company needs to respond to a DOJ document subpoena, there is no reason their theoretically diverging interests should prevent the company’s defense counsel from tapping into the document review work done by the internal investigation counsel to locate responsive documents.

The single greatest beneficiary of this collaboration is the company, which in many circumstances is required to pay the bill for all of the various lawyers. We would think that, by extension, the company’s D&O insurers would also see and appreciate the extent to which collaboration between the various groups reduces the overall legal spend. It seems, however, that many D&O insurers are quite restrained in their enthusiasm, often declining coverage for various categories of fees incurred by the company under numerous theories. One fee category that is almost uniformly declined is fees incurred by internal investigation counsel, which, perhaps coincidentally, also happens to be the largest single line-item in many situations.

When declining coverage for internal investigation fees, insurers often argue that because the definition of "Claim" does not specifically reference internal investigations, fees incurred by internal investigation counsel were not incurred "in connection with a Claim." Insurers also argue that the internal investigation counsel represents only the special committee, which typically is not one of the enumerated categories of "Insureds" under most D&O policies. A related argument is that internal investigation counsel is supposed to be neutral and objective, such that their work cannot be described as defensive in nature and, therefore, cannot be considered "defense costs."

Most policyholders regard these arguments as formalistic and compartmentalized, divorced from the business realities of these "when it rains it pours" situations. For one, the carriers do not give adequate consideration to the fact that much of the internal investigation work (e.g., construction of an electronic document database and obtaining witness statements) is relevant and necessary to defending any securities claim or government investigation, and would need to be performed even in the absence of any internal investigation. In this sense, the insurer’s objection is one of form not substance, as the nature of the substantive work is less relevant to the insurer than the designation of the firm who handled that work (e.g., document review conducted by defense counsel is admittedly covered, but that same work is allegedly not covered merely because it was performed by internal investigation counsel).

Further, the insurers’ arguments tend to disregard the direct and obvious connection between the allegations of and investigation into potential wrongdoing and the coordinated effort taken and paid for by the company to investigate and respond in an appropriate manner. When the allegations surface, all of the attorneys involved, whether they represent the company, the special committee or the individual insureds. need to review documents and interview witnesses to determine the relevant underlying facts that impact their respective clients’ interests. It often is not until much later, if at all, that facts surface which demonstrate that the various parties’ interests are in fact adverse. That the information gained during the earlier investigation phases might be used by the special committee in a manner inconsistent with coverage (e.g., advising the board to pursue litigation against directors and officers) does not justify a wholesale declination of all fees incurred by the special committee.

A few of these issues came up in the recent MBIA v. Federal Ins. Co. coverage action Kevin has addressed (here and here), where the court seemed not to have been overly warm to the legal principles underlying the insurer’s arguments.

Federal argued that the firm which handled the internal investigation, Dickstein Shapiro, represented only the special committee, not the company or any of the other insureds. Although the court dismissed this argument on a factual basis (finding that Dickstein made an appearance on behalf of the company in the securities litigation), it also noted that, independent of this fact, the special committee was comprised of members of the board of directors who were expressly charged with acting in the best interest of the company and who "could readily reach independent decisions without being independent of [the company]." While this portion of the opinion could have been more clear, the court’s decision cuts against both the notion that special committees are necessarily separate "entities" from the company and that their required independence precludes characterizing as "defense costs" the work done on their behalf.

Another aspect of the court’s decision in MBIA is also worth noting. Insurers frequently argue that internal investigation counsel’s work was not performed "in connection with a Claim," but rather was performed "in connection with" something other than a "Claim," e.g., an internal investigation. This argument makes relevant the causal nexus implied by the "in connection with" language. Policyholders often argue that the implied nexus in this non-exclusionary term is very broad, something akin to an incidental or minimal causal connection; for example, the fees are covered if they bear some reasonable relationship to a covered claim. In our experience, insurers appear reluctant to characterize the allegedly required nexus, but by implication seem to suggest something like predominant causation; for example, the fees are covered only if the predominant reason for doing the work was to defend against the covered claim. While it does not appear that the parties in the MBIA case briefed this issue, by finding coverage for the internal investigation fees related to the derivative suits the court arguably recognized that "in connection with" implies only a minimal causal connection in this context.

The insurance bar is likely concerned by the MBIA decision, as it could have widespread implications. It will be interesting to see whether Federal seeks appellate review or whether insurers in the future will simply seek to downplay the significance of a district court decision and attempt to confine it to the facts before the court. 

The D&O Diary would like to thank Cindy and Jeff again for their submission of this guest post. The D&O Diary accepts appropriate guest posts from responsible commentators on topics relevant to this blog. My goal in hosting guest posts is to encourage discussion of important topics and to facilitate the exchange of contrasting points of view. Readers who are interested in submitting guest posts should feel free to let me know using the "Contact" function on this blog. 

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The problems facing many banks in the current economic environment are well-documented. For troubled banks’ directors and officers, the banks’ D&O insurance may represent a last line of protection. But what if the insurers could just cancel the policies? Surprisingly, many bank D&O insurers have that right under their policies, and while cancellation is rare, it is not unprecedented, and some insurers are now invoking that right to shed the risks associated with failing or problem institutions.

As reflected in a January 24, 2010 FinCri Advisor article entitled "Your D&O Insurer Might Be Scouring Your Call Report Looking to Cancel Coverage" (here), the policy forms of many bank D&O insurers have cancellation clauses that permit the insurer to cancel the policies mid-term, either because there is a "material change in the risk" or for any reason at all.

Many of these clauses are found only in policies that were issued on a multiyear basis, but even some single-year bank D&O insurance policies contain cancellation clauses. While many policies also specify that the insurer must give the policyholder 60 days (or more) notice so that the policyholder can try to replace coverage, the fact is that if something serious enough to cause the insurer to cancel coverage has occurred, it likely will be a very difficult time for the policyholder to try to find replacement coverage.

For D&O insurance practitioners who don’t venture into the Financial Institutions arena (or FI as it is known), the very existence of these clauses in bank D&O policies may come as a surprise, since these clauses do not appear in most mainstream commercial D&O insurance policies.

The obvious question is how did a cancellation clause get into bank D&O policies when it is rarely if ever seen in other kinds of D&O insurance policies? Part of the answer is that, particularly with respect to community banks, the D&O insurance marketplace has over the years become both very specialized and intensely competitive.

Before the current troubled bank era began, D&O insurance for community banks became increasingly less expensive. But as buyers became increasingly (or even exclusively) focused on price, some carriers looked for ways to trim coverage. And so a term such as the cancellation clause that isn’t seen in other D&O insurance policies found its way into the basic forms of several community bank D&O insurance carriers.

A neutral observer might question the value of a contract that one party can simply cancel unilaterally. The promise to provide insurance seems tenuous indeed if the insurer can walk away because problems have emerged – which is of course the very circumstance for which buyers purchase insurance in the first place.

All of this does raise the question of why any buyer would agree in the first place to accept a policy that has a cancellation clause. The answer is either that the buyer is unaware the clause is there or the buyer has no other choice.

Given the number of bank D&O insurers that have cancellation clauses in the policy forms, there undoubtedly are many banks whose policies have these clauses. I am guessing only a very small number of these banks (many of whom may have purchased their insurance on a direct basis) have any idea the clauses are there.

The problem is that the market for D&O insurance for banking institutions is in turmoil now due to the number of failed and troubled banks. For banks that are struggling, it may be challenging in the current environment to obtain a policy without a cancellation clause. Or, if they can a policy without a cancellation clause, the coverage afforded may otherwise be restricted (as for example, by the inclusion of a regulatory exclusion or the absence of past acts coverage).

Healthy financial institutions in many instances can still get coverage on a relatively attractive basis. Healthier banks should not have to accept a policy with a cancellation clause. However, even the healthy banks can only avoid the cancellation clause and other undesirable policy features if their advisor is well-informed and knows what to look and ask for.

One added note is that even some bank D&O policies that do not have cancellation clauses have other undesirable features that are almost as bad. For example, the policy form of at least one D&O insurer that is active with community banks does not allow the policyholder the option of purchasing extended reporting period coverage, even in the event of nonrenewal, which could have a similarly negative impact on a bank whose D&O insurance is not renewed. Again the presence or absence of an extended reporting period option is a term that the bank’s D&O insurance advisor will, if well-informed and knowledgeable, be looking for.

For the banks whose D&O insurers hit them with a notice of cancellation, the only recourse may be for the banks to provide their insurers with a "laundry list" notice of circumstances that may give rise to a claim – always a challenging proposition because of the uncertainty of knowing what claims may arise later. But the laundry list may be the only chance the bank has to lock in coverage before it is unilaterally taken away.

All of this underscores the critical importance for banks and for all insurance buyers of involving a knowledgeable and experience advisor in the acquisition of D&O insurance. Without informed advice, policyholders can be left with inadequate insurance protection when problems arise.

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

Background and the January 26 Opinion

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

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

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

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

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

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

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

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

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

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

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

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

Discussion

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

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

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

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

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

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

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

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In an earlier post (here), I wrote about a December 30, 2009 ruling in the MBIA coverage litigation that special litigation committee investigation expenses were covered under a D&O liability insurance policy. As I anticipated, the decision has proven to be controversial.

Two law firms that traditionally act as coverage counsel for D&O carriers recently released memoranda discussing the opinion. The Wiley Rein issued a brief memo (here) discussing the case and its holding. The Edwards Angell Palmer & Dodge law firm released a longer memorandum (here) also discussing the opinion.

The Edwards Angell memo, written by my friend John McCarrick and his colleagues, Maurice Pesso and Peter de Boisblanc, is particularly interesting because opens by reviewing the justification for the insurers’ standard position that special litigation committee expenses are not covered under the typical D&O insurance policy.

The Edwards Angell memo also includes a review of implications of and the likely consequences that flow from the decision. Among other things, the memo stresses that the decision did not hold that special litigation committee expenses will always be covered, but only under the facts presented. The memo also recites the difficulties and logical problems involved with characterizing the special litigation committee expenses as "defense costs" (including the likelihood that plaintiffs might use the characterization as a way of challenging the independence of the special litigation committee.).

The Edwards Angell memo concludes with this observation:

Unless and until the D&O insurers in MBIA press a successful appeal of this ruling to the Second Circuit Court of Appeals, D&O insurers should brace themselves for the likelihood that the MBIA ruling will be cited by policyholder counsel and brokers in an effort to significantly expand the scope of coverage for these kinds of legal expenses and costs, as well as to cover other fees and expenses that an insured can argue were incurred "in connection with" a covered D&O claim.

The memo provides an interesting presentation of the carrier perspective on the decision. Reading the memo, I wondered whether any policyholder-side coverage attorneys had written their own analyses of the decision from the perspective of insured companies. I hope that any readers aware of these alternative perspectives will please send them along to me. I will update this post with any additional materials that are sent to me about the case.

One final note on a related subject -- the Wilmer Hale law firm has an interesting memo about recent developments in shareholder derivative litigation (here), which, among other things, discusses court's' increased scrutiny of special litigation committees, particularly with respect to the  question whether or not the committees are in fact independent.

NAB Update: The closely watched National Bank of Australia case pending before the U.S. Supreme Court on a writ of certiorari from the Second Circuit has now been scheduled for oral argument. According to a post on The 10b5-Daily (here), oral argument in the case, which will address the question of the extraterritorial jurisdiction of U.S. courts over foreign domiciled companies under the U.S. securities laws, is now set for March 29, 2010.

The 10b-5 Daily post also has a link to the Petitioners’ Brief., which argues that under the federal securities laws there are no extraterritorial limitations on the U.S. courts’ jurisdiction. Finally, the blog post also links to a National Law Journal article (here) written by Columbia Law School Professor John Coffee suggesting that, in light of various pending legislative proposals, Congress and the Supreme Court are on a "collision course" on the question of extraterritorial jurisdiction of the U.S. securities laws. Coffee concludes by suggesting that "a legal train wreck might result from opposing approaches to global class actions."

Detailed background regarding the NAB case can be found here.

Another Belated Securities Lawsuit Filing: In prior posts (for example, here), I have noted the phenomenon that developed in the second-half of 2009 where plaintiffs’ lawyers were filing securities class action lawsuit complaints well after the proposed class period cutoff date. In a more recent post (here), I noted that at least one lawsuit first filed in January suggested that this trend has continued in the New Year.

Yet another case filed this week suggests that this trend is continuing. In a January 21, 2010 press release (here), plaintiffs’ lawyers announced that they had filed a securities class action lawsuit in the Northern District of Illinois against Motorola and certain of its directors and officers. The lawsuit relates to alleged misrepresentations about the company’s sales of its RAZR2 telephone handset. The complaint in the case can be found here.

Though the complaint was only just filed, the proposed class period cutoff date is January 22, 2008, a full one year and 364 days prior to the filing date, and just before the expiration of the two-year statute of limitations applicable to ’34 Act claims.

In his comments in connection with the recent release of Cornerstone’s year-end analysis of the securities class action lawsuits, Stanford Law School Professor Joseph Grundfest had a number of choice comments about these belated securities class action lawsuit filings, essentially suggesting that the plaintiffs are scraping the bottom of the barrel (my words, not his) to file these belated lawsuits because they had run out of more meritorious cases to file. Public statements by leading plaintiffs’ attorneys (refer, for example, here) suggest more neutrally that they are just getting around to filing cases that were "backburnered" while the lawyers were concentrating on getting the subprime and credit crisis cases on file.

But whatever the explanation may be for the belated case filings, it is a very distinct phenomenon that has appears to be continuing as move well into 2010.

New SEC Climate Change Disclosure Guidance Ahead?: In prior posts (here), I discussed the possibility that the SEC could issue guidelines for public companies’ disclosures about climate change related issues and exposures. As discussed on the FEI Financial Reporting Blog (here), the SEC has announced (here) that in a meeting on January 27, 2010, it will be considering "a recommendation to publish an interpretive release to provide guidance to public companies regarding the Commission's current disclosure requirements concerning matters relating to climate change."

As the FEI Financial Reporting Blog explains, an interpretive release of this type is designed to provide final guidance on existing disclosure requirements. The blog post speculates that the guidance could be effective immediately upon release.

Cheers: I have joined the Facebook group "A Glass of Wine Solves Everything." (here). In vino veritas, dude. I recently have developed an affinity for two very different kinds of red, Oregon Pinot Noir and Argentine Malbec -- in part because one of the problems I have to solve is that I can't afford the Burgundys, Bordeauxs and Super Tuscans I would prefer. In my next life, my blog will be about wine.

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Among perennial D&O insurance issues are questions whether policy coverage is available for defense expenses incurred in connection with investigative costs, subpoenas and the costs associated with special litigation committees. A December 30, 2009 decision in the coverage lawsuit brought by MBIA against its D&O insurers considered all of these recurring issues, and reached some interesting decisions.

Background

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

In 2001, prior to the policy period, the SEC had issued an Order Directing Private Investigation in connection with certain of MBIA’s loss mitigation insurance products. In November and December 2004, the SEC issues subpoenas to MBIA concerning "nontraditional products." The New York Attorney General also issued subpoenas in November and December 2003 regarding nontraditional products. Both the SEC and the NYAG issues additional subpoenas in March 2005. In spring 2005, MBIA, because of concerns about the cumulative impact in the marketplace, asked regulators to forbear from issuing additional subpoenas and agreed to comply voluntarily with informal document requests.

In October 2005, MBIA submitted an offer of settlement to the SEC in connection with certain specific transactions. In the offer of settlement, MBIA undertook to retain an independent consultant to review MBIA’s accounting for the transactions. In January 2007, the SEC entered a Cease and Desist Order and the NYAG entered an Assurance of Discontinuance, both of which documents largely incorporated the company’s prior offer of settlement. Thereafter the company hired a consultant to undertake the proposed review.

In additional to these regulatory investigations, the company, as nominal defendant, was also sued in two derivative lawsuits, as a result of which the company organized a Special Litigation Committee. An outside law firm "represented the SLC," and according to MBIA, also "represented MBIA through its representation of the SLC." The derivative lawsuits were later dismissed.

MBIA claimed that it has spent $29.5 million in defending or responding to the regulatory investigations and the follow-on litigation. The primary insurer had reimbursed $6.4 million but disputed that it was obliged to reimburse other amount incurred. MBIA filed an action against the two insurers alleging breach of contract and seeking a judicial declaration that the insurers were obligated to reimburse the company for legal fees and other costs associated with the regulatory investigations and the derivative actions. The parties filed cross motions for summary judgment.

The December 30 Ruling

The defendant insurance companies had disputed coverage for the investigative items, in part of the grounds that the matters in connection with which the defense costs were incurred were not "securities claims" within the meaning of the primary policy.

The primary policy defined a "securities claim as "a formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document" that "in whole or in part, is based upon, arises from or is in consequence of the purchase or sale of, or offer to purchase or sell, any securities issued by" the company.

In his December 30 Order, Southern District of New York Judge Richard M. Berman reviewed each category of defense expense separately.

Judge Berman first considered the defendants’ arguments that there was no coverage for fees incurred in responding to the NYAG’s subpoenas because the subpoenas were not a proceeding commenced by the filing of an "order or similar document." Judge Berman first found that the subpoena, which literally "commanded" compliance, was an "order" within the "common understanding" of "an ordinary businessman." He found further than even if it were not an "order" it was "sufficiently a ‘similar document’ that triggers coverage under the policy."

Judge Berman then considered the certain aspects of the SEC’s investigation, which the defendant insurers contended pertained to "traditional reinsurance" rather loss mitigation products. The defendants argued that the SEC’s 2001 Order Directing Private Investigation pertained only to the investigation of loss mitigation products, and so the SEC’s investigation of traditional reinsurance transactions was not pursuant to an "order."

Judge Berman rejected this argument among other reasons on the grounds that "Defendants have offered no persuasive evidence to support their argument that the SEC ran a series of concurrent investigations."

The defendant insurers also argued that the NYAG’s oral requests for documents pertaining to traditional reinsurance transactions were not pursuant to an "order." Judge Berman found that "defendants point to no persuasive evidence to suggest that the NYAG’s request for documents" relating to the reinsurance transactions "were part of separate investigations."

MBIA had also sought reimbursement for its costs incurred in connection with the independent consultant. Judge Berman found that there was no coverage under the policy for the costs associated with the independent consultant because MBIA "did not permit Defendants to effectively associate with it" because it did not inform the insurers about the independent consultant (and arguably did not get the insurers consent to agree to the independent consultant) "until at least ten months after it had committed to retaining" the independent consultant.

Finally, Judge Berman found that there was coverage under the policy for the fees incurred by counsel for the special litigation committee. MBIA had argued that the law firm had represented MBIA through its representation of the SLC. The carriers argued that the SLC was, by definition, independent, and therefore its counsel could not have represented the company.

In rejecting the insurers’ arguments, Judge Berman found that the SLC’s counsel had appeared as counsel for MBIA in the derivative actions and had filed pleading in the actions on behalf of MBIA. But even assuming that the law firm represented only the SLC, Judge Berman found there would still be coverage, because the SLC was composed of individual members of MBIA’s board who were acting pursuant to delegated authority from the board. Judge Berman noted that "the SLC could readily reach independent decisions without being independent of [MBIA]."

Discussion

The questions whether the kinds of defense fees in dispute in this case will be covered is often going to be a factor both of the policy language at issue and the specific facts involved. To a certain extent, Judge Berman’s decision may simply be a reflection with a very distinctive set of facts. In particular, it is a rather unusual feature of this set of circumstances that all of the disputed legal fees were incurred after the SEC had entered a formal order of investigation. Given that, it seems as if the only remaining dispute was whether or not the other investigative actions of the regulators were or were not related to the Order.

Judge Berman’s finding of coverage for the SLC legal counsel’s expense may also be a reflection of the fact that the law firm also entered an appearance on the company’s behalf in the derivative suit. These circumstances are not always present in connection with disputes over SLC’s counsel’s fees (although that fact certainly does not answer the question of the SLC’s counsel’s fees incurred prior to making an appearance in the derivative suit.)

But even though the decision may be a reflection of the particular facts involved, Judge Berman’s ruling nevertheless is significant as an example where a court found coverage for fees incurred with regulatory subpoenas, oral document requests, and special litigation counsel fees.

In particular, Judge Berman’s finding that, at least under these circumstances, the policy covered oral document requests and that the policy would have covered the SLC counsel’s defense even if it had not been counsel of record for the company in the derivative suit are particularly noteworthy.

Judge Berman’s finding the policy covered the SLC counsel’s expense because the SLC, though independent, was a committee of the Board operating pursuant to the Board’s delegated authority, is particularly noteworthy, and may represent a basis on which other insureds may seek to argue for coverage for SLC counsel fees.

This interesting case combines a number of frequently disputed issues. I expect that many readers may have reactions to this ruling and I would be very interested in hearing readers’ thoughts.

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2009 was an eventful year, with significant developments across a wide variety of economic, financial, judicial and legislative fronts. With the arrival of the New Year, it seems appropriate to take a look back at the past year’s most significant D&O developments.

So, in the finest tradition of year-end punditry, here is The D&O Diary’s list of The Top Ten D&O Stories of 2009.

1. Credit Crisis Litigation Wave Wanes: The subprime and credit crisis-related litigation wave that began in February 2007 continued to surge as 2009 began, but as the year progressed, the long-running wave finally seemed to lose momentum. During the wave’s nearly three-year duration, there were by my count 205 subprime and credit crisis-related securities class action lawsuits filed, 62 of which were filed in 2009, primarily during the first half of the year.

NERA’s annual securities litigation survey noted that during 2008, over 40% of all filings had involved credit crisis cases, but that this proportion decreased to "around 30%" in 2009, and "by the second half of the year, credit crisis filings began to slow down." Nevertheless, the NERA report also noted that "total levels of filings have remained relatively high," as "standard cases appear to have made up much of the decrease in filings related to a slowdown in credit crisis litigation" during the second half of 2009.

2. Plaintiffs’ Lawyers Turn to "Backburnered" Cases: One of the main drivers in the return to the filing of "standard cases" in the second half of 2009 was belated filing of cases to which the plaintiffs’ lawyers returned after the credit crisis cases died down. Many of the cases during the second half of 2009 were filed long after the purported class period cut off date, a phenomenon I noted most recently here. According to public statements of one leading plaintiffs’ attorney, the plaintiffs’ lawyers are going back to cases that they have "backburnered for two years."

By my count, 22 of the 94 securities class action lawsuits in the second half of the year were filed more than a year after the proposed class period cut-off date. Indeed, NERA noted with respect to the cases that were filed in the second half of 2009 that the average time to filing from the end of the class period to the filing date had grown to 279 days, compared to historical averages of 161 days, and only 69% of the cases in the second half of the year were filed within one year of the end of the class period, compared to historical averages of 84%.

The plaintiffs’ lawyers efforts to work off the backlog that developed while they were concentrating on the credit crisis cases poses a challenge for D&O underwriters, because it means that companies with long distant stock price drops could still find themselves getting dragged into securities litigation long after the event. As a result, it is hard for underwriters to be sure when a company is "out of the woods."

Moreover, the arrival of the belated filings still seems to be going strong, as a number of the new securities suits filed in December 2009 presenting these same backlog characteristics. It seems probable that this trend will continue, at least for the short run, as we head into 2010.

3. The Stockpile of Subprime and Credit Crisis Cases Slowly Makes Its Way through the System: The number of subprime and credit crisis-related filings may finally have slowed, but due to this nearly three-year onslaught of new cases, there is a stockpile of accumulated lawsuits that still are just beginning to be resolved.

As NERA noted in its annual securities litigation survey, over 80% of the subprime and credit crisis cases remain pending. About 15% of the cases have been dismissed, and only about 4% have been settled. This proportion of settlements to dismissals is consistent with historical experience, in which cases are more likely to be dismissed than to settle in the first few years after filing.

As reflected in my own running tally of subprime and credit crisis-related lawsuit dismissal motion rulings (here), there have been 28 dismissal motion rulings granted (eleven with prejudice) -- although in three cases in which dismissal motions were initially granted, the subsequently filed amended complaint survived renewed dismissal motions. The three cases in which the renewed motions were denied include the Washington Mutual and PMI Group cases (about which refer here and here). One dismissal (in the NovaStar Financial case) has already withstood appeal.

On the other hand, dismissal motions have been denied in whole or in part in 14 subprime and credit crisis-related cases, including several high profile cases, such as the cases involving New Century (here), Countrywide (here) and Accredited Home Lenders (here).

Though only a small number of subprime and credit crisis cases have settled, the settlements to date are impressive. The settlements include not only the outsized Merrill Lynch settlements (about which refer here), but also include significant settlements in other cases as well, including the Beazer Homes and Accredited Home Lenders cases.

With only a small percentage of these cases yet resolved, it is clear that the resolution of the subprime and credit-crisis related cases will remain an important part of the litigation landscape for years to come.

4. Bank Failures Mount: In a troublesome development with many worrisome implications, 140 lending institutions failed in 2009, by far the largest number of annual bank closures since the end of the S&L crisis. (By way of comparison, in 2008, there were 25 bank closures.) The number of bank failures increased as the year progressed, as 95 of the 140 bank failures (or roughly 68%) took place in the second half of 2009.

Though the bank closures were spread across 32 states, more than half of 2009 failed banks were concentrated in just four states: Georgia (25), Illinois (21), California (17) and Florida (14).

Despite the mounting numbers of bank failures, there has not yet been significant amounts of D&O litigation involving former directors and officers of the failed institutions. The are significant signs, however, that significant amounts of failed bank litigation ahead. Not only have investors and even employees of some failed banks filed lawsuits (about which refer here), but the FDIC has also shown a commitment to preserving its prerogative to assert claims against the directors and officers of failed banks. The FDIC has also begun to file notices of claims, in an attempt to preserve insurance against which to recover for claims against the directors and officers.

The FDIC’s latest quarterly banking report shows that it reckons there were 552 "problem" institutions as of September 30, 2009, up from just 416 at the end of 2Q09. With the numbers of both failed and troubled banks growing, and with the signs already pointing toward increased litigation involving these institutions, it seems likely that failed bank litigation will be a significant part of D&O litigation activity in 2010.

5. Business Bankruptcies Swell: According to the latest quarterly report of the Administrative Office of the U.S. Courts (about which refer here), business bankruptcy filings were up 52 percent in the 12 months ended September 30, 2009. The number of business-related bankruptcy filings has increased in the 12-month period preceding the quarter end of each quarter since the end of the third quarter 2006. The highest monthly total was in April 2009, when there were 5,621 business-related bankruptcies, compared to 4,853 in September 2009.

The possibility of a bankruptcy filing remains a significant threat for financially troubled businesses. As a general rule, D&O claims follow the filing of a bankruptcy petition.

Bankruptcy-related claims present a host of complications, not least of which is the intricate way that D&O insurance policies respond in the bankruptcy context. One recent development illustrating the difficulties that can arise in the bankruptcy context was the July 2009 decision in the Visitalk case (about which refer here), in which the Ninth Circuit upheld the carriers’ denial of coverage for a lawsuit brought be a company as debtor in possession against former directors and officers of the company, as a result of the policies insured vs. insured exclusion.

The likelihood of further business bankruptcies, with the prospect of related D&O claims, suggests that these kinds of coverage complications will appear frequently during 2010.

6. Rising Derivative Lawsuit Settlements: Threaten Increased Excess Side A Losses: The $118 million settlement in August 2009 of the Broadcom options backdating-related derivative lawsuit is the latest in a series of massive derivative lawsuit settlements. But perhaps even more significantly from the D&O insurance industry’s perspective, the Broadcom settlement appears to be the first instance where Excess Side A insurers were called upon outside of the insolvency context to contribute significantly toward settlement.

As detailed in greater length here, Broadcom’s Excess Side A insurers contributed $40 million toward the $118 million settlement. If nothing else, the settlement certainly underscores the value to companies (and their directors and officers) of the Excess Side A product, even outside the insolvency context.

The Broadcom settlement also represents a significant development for D&O insurers, who up until now have enjoyed the opportunity to offer Excess Side A insurance in a relatively low cost environment, particularly outside of the insolvency context. The Broadcom settlement highlights the potential for Excess Side A insurers to sustain significant losses on this product. The increasing incidence mega settlements, along with the growing numbers of business insolvencies, underscore the growing possibility for these kinds of losses.

7. Ponzi Schemes Emerge, Lawsuits Follow: The dramatic December 2008 revelation of Bernard Madoff’s massive Ponzi scheme proved to be only the first in a series of Ponzi scheme disclosures. According to a December 29, 2009 AP story (here), more than 150 Ponzi schemes collapsed in 2009, compared to "only" 40 in 2008. Among others, the schemes revealed in 2009 included the alleged Stanford Financial Group fraud and the alleged fraud of disbarred Florida attorney Scott Rothstein.

The one inevitable product of these disclosures has been the subsequent emergence of related litigation. The Madoff scandal along is its own litigation phenomenon. Indeed, the list of just the Madoff-related lawsuits – most of which were filed during 2009 – runs to over 25 pages. The Stanford Financial scandal also generated its own mass of litigation, beginning shortly after the fraud was revealed in February 2009. Many of the other Ponzi schemes have also generated their own burst of related litigation activity.

All of this litigation has produced a flood of claims activity for insurers. To be sure, many of these claims are more likely to trigger losses under E&O or even Fiduciary liability policies, rather than D&O policies. However, D&O insurance is implicated in a number of these suits, and the sheer claims volume as well as the accumulating costs of defense undoubtedly will adversely affect the results of D&O (and E&O) insurers for some time to come.

8. Supreme Court Grants Cert in Two Securities Cases: There was a time not too long ago when the U.S. Supreme Court only rarely took up securities lawsuit appeals. But in recent years, securities cases have become increasingly common on the Supreme Court’s docket. Just within the last couple of terms, the Court has handed down the Tellabs and Stoneridge cases (about which refer here and here).

Even with these recent developments, it remains noteworthy when the Supreme Court agrees to hear securities related cases, and for that reason it is significant that during 2009 the Supreme Court agreed to hear the appeals of two different securities suits. These two cases potentially could have a material impact on securities litigation procedure and jurisdiction.

First, in May 2009, the Supreme Court granted Merck’s petition for a writ of certiorari in the securities class action relating to the company’s disclosures about Vioxx. The Supreme Court will in this case address the question of what is required to establish "inquiry notice" sufficient to trigger the running of the two-year statute of limitations for private securities suits under the ’34 Act. Background on the Merck case can be found here.

Second, in November 2009, the Supreme Court granted cert in the National Australia Bank case. As a result of taking the case, the Supreme Court is likely to confront generally the question of extraterritorial application of the U.S. securities laws and will address specifically the question of when U.S. court properly can exercise jurisdiction over the claims of so-called "f-cubed" claimants (that is, foreign investors who bought their shares in foreign-domiciled companies on foreign exchanges). Background on the NAB case can be found here.

Both of these cases are likely to be decided during 2010. The Supreme Court heard argument in the Merck case in late November and it will likely hear argument in the NAB case during 2010. These cases potentially could have a significant impact on many securities lawsuits. The Merck case could affect frequently recurring statute of limitations issues and the NAB case could affect jurisdictional issues, and perhaps other concerns, in cases involving foreign companies (though pending Congressional initiatives could wind up superseding the Court on the jurisdiction question, about which see below).

While the outcome of these cases remains to be seen, the very fact of the Supreme Court’s involvement makes these cases significant. The anticipated rulings likely will represent among the more significant developments in 2010.

9. Congress Tackles Financial Reform: As a result of the political and financial events of the past two years, Congress is now poised to address a host of issues affecting both the financial markets and the securities laws, and some of the Congressional initiatives commenced in 2009 likely will have a significant impact on securities litigation.

The House of Representatives has already approved "The Wall Street Reform and Consumer Protection Act of 2009" H.R. 4173 (here), a sprawling 1279-page Bill that would institute a number of reforms that could have dramatic impact on the financial services industry.

As I detailed in a prior post (here), the Act also incorporates a number of provisions that could significantly affect securities litigation. Among other things, the Act provides a statutory standard for extraterritorial jurisdiction of the securities laws in certain circumstances. The Act also clarifies the pleading standard applicable to private securities lawsuits against the credit rating agencies. The Act would also significantly increase the SEC’s funding.

The House Bill must now be reconciled with several financial reform proposals pending in the Senate. Among other competing Senate initiatives are two bills introduced by Senator Arlen Specter.

The first of these, "The Liability for Aiding and Abetting Securities Violations Act of 2009," S. 1551 (here), would legislatively overturn Stoneridge and allow private securities suits for aiding and abetting claims. (Refer here for a discussion of this Bill.)

The second of the bills, "The Notice Pleading Restoration Act of 2009," S. 1504 (here, would legislatively overturn the Iqbal case and set aside the "facial plausibility" pleading requirement. (Refer here for a discussion of this Bill.)
 

While the legislative proposals are likely to go through many changes before financial reform legislation finally is enacted, these initiatives suggest that whatever finally becomes law will likely include provisions that could significantly impact securities litigation in the years ahead. It seems probably that Congress will enact financial reform legislation in some form during 2010, and so these Congressional initiatives could prove to be among next year’s top stories as well.

10. Significant D&O Exposures Emerge Outside the United States: For many years, the increasing threat of significant D&O exposures outside the United States has been a recurring theme amongst D&O insurance professionals. But in 2009, there were several significant developments demonstrating that D&O exposures outside the U.S. are no longer merely theoretical possibilities.

Perhaps the most significant developments in that regard are the two December 2009 rulings by Ontario Superior Court Justice Katherine van Rensberg allowing the securities lawsuit pending against IMAX and certain of its directors and officers to go forward, and certifying a global class of investors on whose behalf the case will now proceed. Legislation permitting this type of lawsuit in Ontario had been enacted several years before, but the IMAX case represented the first instance in which a lawsuit filed under the relatively new statutory provisions was allowed to proceed, as discussed at greater length here.

Though the IMAX case is still only in its earliest stages, a separate development in the liability case filed in Germany against certain directors and officers of Siemens underscores the fact that lawsuits outside the U.S. are potentially capable of producing massive D&O insurance losses.

As discussed at greater length here, in December 2009, Siemens reached a 100 million euro settlement with its D&O insurers in connection with claims arising from the company’s bribery scandal.

These developments are interesting and significant in and of themselves. But they are perhaps even more significant to the extent they underscore the fact that D&O exposures outside the U.S. are both growing and substantial. Clearly, the U.S. no longer has serious liability exposures for directors and officers.

Conclusion

One of the most noteworthy aspects of the 2009’s top D&O stories is that extent to which many of them indicate the trends we can expect to emerge or to continue in the year ahead. Certainly, the number of banks that failed during 2009 suggests the probability during 2010 of extensive litigation against the directors and officers of failed banks. The anticipated decisions of the Supreme Court and the probable Congressional action on financial reform legislation are also likely to be among the significant developments in 2010.

For that matter, the continued resolution of credit crisis-related litigation and the Ponzi scheme lawsuits are also likely to be a significant part of the litigation activity in 2010 (and for years to come).

What lies ahead in the coming year remains to be seen. But based solely on the events during the year we just concluded, 2010 promises to be both interesting and action packed. All I can say is that it is a great time to be a blogger.

More Year End Lists: As we head into 2010, a number of my fellow bloggers have also produced retrospective posts about the year we just concluded.

Francis Pileggi of the Delaware Corporate and Commercial Litigation Blog has published a list of the "Top 5 Corporate and Commercial Cases from Delaware for 2009" (here).

In an interesting complement to Pileggi’s post, University of Denver Law Professor Jay Brown has begun a series on his Race to the Bottom blog of "Delaware’s Top Five Worst Shareholder Decisions for 2009" (here). This list apparently will be published in a series of posts, the first of which may be found here, and the rest to be published in the days ahead.

The FCPA Blog has published its annual "FCPA Enforcement Index" (here), which among other things, tallies up the SEC and DOJ enforcement actions under the FCPA, as well as FCPA-related civil litigation.

The Drug and Device Law Blog has a list of the "Top Ten Prescription Medicine/Medical Device Decisions of 2009" (here).

Legally related but more on the entertainment end of the continuum, Above the Law published its list of its "Top Ten Most Popular Stories of 2009" here.

Randy Maniloff and Sarah Damiani’s "Ninth Annual Review of the Year’s Ten Most Significant Insurance Coverage Decisions" (including the "Second Annual Insurance Coverage for Dummies) can be found here.

And finally, with a look ahead, my friend Evan Rosenberg of Chubb has written "A D&O Liability Wish List for 2010" which appeared in the January 2010 issue of Directors & Boards magazine, here.

Early January Observation: It is a truth universally acknowledged that early January is a rotten time to use a health club. I have belonged to many different clubs in many different cities, and the invariable pattern regardless of the facility or the location is that after New Year’s the clubs fill up with earnest, first-time users. This year has proven no exception.

Usually, by the 15^th of the month or so, all of the hubbub dies down and the only ones in the club are the regulars. My advice to anyone who has made a New Year’s resolution this year to start going to the gym is – don’t get discouraged, working out will be much more enjoyable after the middle of the month or so. Hang in there.

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In many prior posts (refer here), I have suggested that FCPA-related losses could represent a growing D&O exposure. In a recent demonstration of just how significant these kinds of exposures can be, Siemens disclosed  earlier this week that it has reached a 100 million euro settlement with its D&O insurers in connection with the claims arising from the company’s bribery scandal. The filing, which incorporates the insurance settlement documentation, raises a number of interesting issues.

In its December 8, 2009 filing of Form 6-K (here), Siemens reports that on December 2, 2009, the company reached a settlement agreement with its D&O liability insurers, while simultaneously announcing that it had also reached settlements with a number of its former directors and officers against whom it has asserted damages claims arising out of the bribery scandal. The settlements include the agreement of the company's former CEO Heinrich von Pierer to pay 5 million euros, and of his successor, Klaus Kleinfeld, to pay 2 million euros. Other former board members agreed to pay amounts ranging from 1 million euros to 3 million euros.

The filing explains that Siemens had a total of 250 million euros of D&O insurance coverage, arranged in five layers of 50 million euros each. Each layer had a lead insurer as well as participating coinsurers. The settlement agreement, which can be found in Annex 10 to the filing, identifies the lead insurers and the participating coinsurers for each layer.

The insurance settlement requires a payment to Siemens of up to 100 million euros, consisting of two parts: a payment of 90 million euros (against which prior defense payments of 5.5 million euros are to be credited) and as well as the payment of an additional fund of 10 million euros. The 10 million euro fund is to be maintained for the defense of future claims as well as for the satisfaction of "justified claims." that are asserted against former Board Members based on the bribery allegations or that have no connection with bribery allegation but for which coverage would have otherwise have been available under the D&O insurance program.

All of the layers in the Siemens D&O insurance program participated in the settlement, with each successive layer contributing a proportionately smaller percentage of the layer's 50 million euro limit.. (The percentage participations applicable to each layer are specified in the settlement agreement.) The 10 million euro fund is to be managed by the lead insurer on the primary layer on behalf of all the insurers.

The settlement agreement recites that the insurance settlement was the result of "intensive discussion" and that the Insurers had previously indicated that coverage might be denied on the grounds of, among other things, "pre-contractual knowledge and/or fraudulent/intentional violations of duties, and/or certain rights by unilateral declaration [that] can be exercised, which would lead to retroactive rescission of the D&O insurance." The parties reached the settlement in order to avoid the need to litigate these issues as well as to avoid the need for Siemens to pursue an action against … former Board Members who settled with Siemens in order to establish their liability as a precondition for the obligation to provide coverage."

Siemens’ SEC filing also reflects the settlement agreements reached separately with various former company officials. The filing recites that in connection with the individual settlements the individuals have agreed "not to draw on the D&O insurance coverage" in connection with their agreed payments to the company.

The agreement is subject to shareholder approval, which will be determined at the company’s January 26, 2010 shareholder meeting. (The shareholders will also vote on the individual settlements as well). The agreement clarifies that upon the effectiveness of the settlement, the insurance policies will be "retroactively terminated."

If it is "determined by a non-appealable court decision that individual Former Board Members intentionally or knowingly … violated their duties," then the Insurers shall be entitled to ask for reimbursement of defense costs paid to the respective former Board Member. The lead primary insurer is designated to administer this portion of the agreement.

There are a host of interesting things about this settlement.

The first is the marginal note accompanying the settlement stating that Michael Diekmann, a member of Siemens’ Supervisory Board, is the chairman of the Management Board of the parent holding company of the lead insurer on Siemens’ primary D&O insurance policy. The filing states that "Mr. Diekmann did not participate in the consultations and decisions pertaining to the Coverage Settlement." Call me cynical, but even if he didn’t participate in the consultations, this connection didn’t exactly impede the settlement either, if you take my meaning. To me this fact seems like it might help explain how there was any settlement at all, rather than the mother of all European D&O coverage lawsuits.

The second interesting thing is the way the D&O insurance policies are responding. The insurers are making a claims payment directly to the company, for claims that have been asserted by the company against its former officers. Unless the company’s European-issued insurance policies lack the kind of Insured vs. Insured exclusion that is standard in D&O policies issued in the U.S., there is something very peculiar about this payment. Even if the company itself is not an insured under the policy, it would seem like there would be an exclusion to protect against the possibility of collusive claims. Of course, there might have been such as exclusion in Siemens program and it was simply compromised as part of the settlement. (Readers who can help rationalize this apparent Insured vs. Insured problem are cordially invited to clarify, using this blog’s comment function.)

UPDATE: A knowledgeable European reader who prefers anonymity sent me a note with the following observation:"Regarding the payment towards the company we usually don´t carry IvI-exclusions over here in Germany. Most of the claims are made by the companies against individual directors and officers, word is that it´s around 80% or more of the times. We are basically still in the fledging stages of D&O litigation over here, D&O coverage was allowed in 1986, distribution really didn´t took off until the end of the 90s. The mentality over here regarding the pursue of claims against your directors and officers is totally different than in the US. Until the middle of the 90s, courts hadn´t even ruled on supervisory boards being forced to pursue claims against directors and officers."

The other thing about the insurers’ 90 million euro payment (less defense expenses previously paid) is the question of what exactly it represents. Simultaneously with the insurance settlement, Siemens settled its claims against most of the former company officials. So those claims have been resolved by individual payments for which the individuals are prohibited from seeking insurance. There are remaining claims against other individuals, but that is what the 10 million euro fund is for. So what exactly is the 90 million euro (less prior defense expense) payment for? Of course, the company has incurred literally billions of costs, expenses, fines and penalties in connection with the bribery scandal, but I don’t think the insurers are paying for the company's own scandal related expenses. 

The settlement agreement recites that, among other things, the insurance settlement relieved the company of the need to file and pursue actual lawsuits against former board members. I guess the internal logic of the settlement agreement is that the company could have pursued the lawsuits, and if they did, each would have to be litigated and separately settled, and the insurer would have to pay (assuming the claims were covered). The insurance settlement in effect says that we are just going to cut out all the intervening steps and compromise everything for a single payment.

The third feature is the way the settlement incorporates a settlement fund for future losses. It is on the one hand an escrow fund, but on the other hand it is more like insurance, or perhaps the residue of insurance with certain insurance-like attributes (e.g., it only applies to "justified" claims) The insurers are in effect providing a limited amount of insurance, but in a bargained down amount, with many fewer conditions.

Fourth, to the extent the insurance policies provided any type of insurance coverage for securities claims, the compromise and termination apparently precludes the availability of insurance in connection with the securities class action lawsuit filed in the Eastern District of New York last week, in which the plaintiffs alleged violations of U.S. securities laws solely against Siemens. (The $10 million fund would not be available in connection with this claim, because the claim was filed solely against the company, but the fund was set up only for claims asserted against former board members.)

Finally, I wonder what this settlement and the company’s settlements with the individual former company officials do to the derivative lawsuit that was filed in New York earlier in connection with the bribery scandal (refer here, see page 18). It is entirely possible that that case fell by the wayside earlier on, or that it was preempted by the claims the company itself asserted against the individuals. But it is an interesting question what impact these developments would have on the New York derivative lawsuit if it were still an active case. (Readers who may have any insight into the status of the derivative lawsuit are encouraged to provide updated information via the comment feature of this blog.)

Whatever else may be said about the settlement, it clearly represents a massive hit to the European D&O insurers. Hits on this scale may have become almost commonplace in the U.S., but this type of loss is still represents an extraordinary D&O insurance development in Europe. I wonder if this settlement is a game changer for the European D&O insurance community. UPDATE: Readers have advised me that massive D&O settlements on this scale are unfortunately becoming all too common in Europe as well; one example cited is the recent 57.5 million euro settlment involving EM.TV.

Finally, it is worth noting that the massive amount of the insurance settlement underscores the extent of the exposure that bribery-related claims represent. Though the Siemens case is extraordinary on many levels, the kind of insurance losses on claims related to bribery-related allegations are becoming increasingly common. As the Siemens insurance settlement demonstrates, the exposures are clearly not limited just to the United States.

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In a series of recent rulings in coverage litigation arising out of the 2007 collapse of Brookstreet Securities Corporation, a California-based securities broker-dealer, Central District of California Judge Cormac Carney addressed the claims of several claimants to the proceeds of a professional liability insurance policy that had insured the defunct company. Though the rulings are narrow and tied to the specific facts presented, the issues in dispute are likely to recur in claims arising from the subprime meltdown and accordingly the rulings may be of more general interest on that basis.

Background

Brookstreet provided broker dealer services nationwide until mid-2008 when the company experienced a financial collapse. The company ceased operations in June 2007 and is now insolvent.

Brookstreet was insured under a Securities Broker Dealer Professional Liability Insurance Policy for the period November 8, 2006 to November 8, 2007. The policy provides coverage for claims made against Insured Persons for actual or alleged Wrongful Acts in the rendering of "Professional Services." The policy had limits of $3 million.

The policy is an express "claims made and reported" policy, requiring in order for coverage to apply both that the claim be made within the policy period and that notice of claim be given within thirty days and during the policy period.

The insurer brought an action for interpleader and posted a $3 million bond. The insurer then filed three separate motions for summary judgment as to certain separate groups of interpleader defendants, all of whom are in turn claimants against Brookstreet or certain of its former directors, officers or employees.

Judge Carney’s Rulings

In a three separate rulings, Judge Carney addressed each of the insurer’s summary judgment motions.

Claims Made/Late Notice Issues: First, in a November 20, 2009 opinion (here), Judge Carney addressed the insurer’s motion for summary judgment as to the defendant claimants who had not made their claim against Brookstreet prior to the policy’s expiration or with respect to whose claims Brookstreet had not provided notice of claim to the insurer prior to the policy’s expiration.

Judge Carney quickly granted the insurer’s motion as to the claimants whose claims were made after the policy’s expiration, or with respect to whose claims Brookstreet had not provided notice of claim to the insurer during the policy period.

The more interesting questions about notice sufficiency arose with respect to the claimants who had made their claims during the policy period and with respect to whose claims Brookstreet had provded notice of claim during the policy period, but with respect to whose claims Brookstreet had not provided notice within the 30-day period required under the policy.

Judge Carney, enforcing the policy’s notice requirements strictly, found that the insurer was entitled to summary judgment even as to this latter group of claimants. Judge Carney found that the 30-day notice requirement was a "condition precedent" to coverage and that "to force" the insurer to have to demonstrate prejudice in order for the notice provision to be enforced "would be to rewrite the insurance contract, and the Court is unwilling to take this step."

Derivative Claim Exclusion: The insurer had also moved for summary judgment as to those claimants whose claims arose out of or were based on transactions involving Collateralized Mortgage Obligations (CMO). The insurer relied upon a policy exclusion precluding coverage for claims "based upon, arising out of or attributable to the sale, attempted sale, or servicing of … any type of …derivative." Relying on this exclusion, the insurer argued that the CMOs are derivatives, and therefore the policy precluded coverage for claims relating to the CMOs.

In a November 20, 2009 ruling (here), Judge Carney concluded, based on extensive material provided by the insurer, that CMOs are "derivatives" within the meaning of the policy. Accordingly, he granted summary judgment as to those claimants whose claims were based on CMOs.

Interrelated Acts: The insurer had also moved for summary judgment as to a claimant who asserted that a Brookstreet employee had mismanaged her investments, through a pattern of "churning, making unauthorized trades, buying and selling high risk stocks, and failed to advise [her] of investment losses" during the period 1996 though June 2006.

The insurer argued that her claim arose out of an Interrelated Wrongful Act that first occurred prior to the policy’s September 10, 2002 retroactive date. The insurer further argued that the pre- and post-September 10, 2002 conduct constituted a single, non-covered Interrelated Wrongful Act. The claimant asserted that each of the improper acts was a separate Wrongful Act, and that each time Brookstreet failed to supervise its employee, it also committed a new and discrete Wrongful Act.

In a November 18, 2009 ruling (here), Judge Carney held that while he "does not discount the possibility that [the employee’s] actions may have constituted an Interrelated Wrongful Act …there are genuine issues of material fact as to whether the acts after September 10, 2002 were interrelated with those occurring before that date." Because a "reasonable jury could conclude" that each time the employee "made an unauthorized trade, churned [the claimant’s account] or bought and sold high risk stocks" each was a separate Wrongful Act.

Discussion

Judge Carney’s rulings are interesting in and of themselves, but they are also interesting for what they suggest more generally.

First, his holding that the claims based on CMOs were precluded from coverage under the Brookstreet policy’s exclusion for derivatives claims is a reminder that the way insurance policies respond to many of the current claims based on complex financial instruments could involve a host of complicated insurance issues.

Although the exclusion that the CMO claims triggered in the Brookstreet case is peculiar to the specific type of insurance policy involved in that case, similar questions could arise under other policies in connection with other claims relating to complex investment securities and other financial instruments.

Many of the types of recurring claims asserted in the current litigation wave (e.g., the auction rate securities suits and the Madoff feeder fund lawsuits) present allegations of the type for which professional liability policies like that involved in the Brookstreet case were designed to respond. However, as the Brookstreet case shows, there potentially could be a host of complex coverage issues associated with many of these claims, depending on the facts alleged and the specific policy language involved.

Second, Judge Carey’s ruling on the interrelatedness issue is a reminder of how difficult interrelatedness questions can be. The term "interrelated" is neither defined in the typical policy nor is it self-defining. At a certain level of generalization, everything in the universe is interrelated, and at the same time, at another level, nothing is interrelated. What makes something interrelated for insurance coverage purposes can become quite situational and subjective, which leads many judges, like Judge Carney here, to want to leave interrelatedness questions to the jury.

Many of the cases in the subprime and credit crisis litigation wave present interrelatedness questions. Different complaints against the same or similar defendants in different policy periods raise the question whether one or several policies have been triggered. Judge Carney’s ruling in this case shows how difficult it may be for carriers seeking to rely on interrelatedness arguments. My own experience, consistent with Judge Carney’s ruling, is that courts tend to resolve interrelatedness questions in a way that maximizes the amount of insurance available.

Finally, Judge Carney’s rulings on the claims made and late notice issues are largely unremarkable, except as pertains to the question of the timeliness of notice for notices provided within the policy period but beyond the 30-day notice period. Judge Carney strictly enforced the policy’s 30-day notice requirement, and declined to even consider arguments based on the absence of prejudice.

Judge Carney’s literal enforcement of the notice requirement is is particularly noteworthy in that his ruling operated to preclude coverage for the claims of claimants where were in no way themselves involved with or responsible for the late provision of notice. ‘

In any event, Judge Carney’s rulings present an interesting case study. Special thanks to a loyal reader for providing me with copies of Judge Carney’s rulings.

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Pop quiz: the law of which jurisdiction should govern a coverage dispute arising under D&O insurance policies issued by U.S-domiciled insurers to an NYSE company incorporated in Delaware with its headquarters in Oregon? If you find the answer "British Columbia" as surprising as I do, read on. The court decision discussed below could have important implications for the typical U.S. D&O policy, with its extension of "worldwide coverage," particularly as both commerce and litigation become increasingly global.

Background

Now-bankrupt forest products company Pope and Talbot, Inc. was incorporated in Delaware and had its corporate headquarters in Portland, Oregon. Until its bankruptcy, its shares traded on the NYSE. Pope and Talbot conducted business through several operating subsidiaries, the largest of which was P&T Ltd., a Canadian federally chartered company with its principal operations in British Columbia. The bulk of Pope and Talbot’s operations ran through P&T Ltd. and the bulk of Pope and Talbot’s employees were employed by P&T Ltd.

P&T Ltd. is now in receivership. PricewaterhouseCoopers is the receiver for P&T Ltd. PWC, in its role as receiver, has instituted an action in British Columbia seeking a judicial declaration of coverage under the parent company’s D&O insurance policies for claims against P&T Ltd.’s directors and officers brought by former P&T Ltd employees under the Canadian Business Corporations Act for unpaid wages.

Pope and Talbot’s D&O insurance program was structured in several layers, involving three U.S. domiciled insurers. The negotiation and placement of the policies took place in the United States.

In a prior ruling, British Columbia Supreme Court Justice Paul Walker determined that the British Columbia court had jurisdiction over PWC’s declaratory judgment action. The insurers then sought a declaration that Oregon law would govern the dispute.

The November 12 Opinion

In his November 12, 2009 decision (here), Justice Walker determined that British Columbia law is the proper law to be applied to the interpretation of the policy.

He began with the determination that the parties intended different laws to apply to different parts of the policy (a choice of law principle known as dépeçage). In reaching this conclusion, Justice Walker referenced several different parts of the policies at issue, including in particular the primary policy’s definition of "Loss," which contained a provision specifying that the policy’s coverage for punitive and exemplary damages would be determined under the law most favorable to the insured. Justice Walker also referenced the policy’s Oregon state amendatory endorsements, which specified that Oregon law would govern any disputes regarding alleged misrepresentations in the insurance application.

Justice Walker determined that given these clause-specific choice of law provisions, and given the absence from the policies of any general choice of law provisions, the "proper law" governing the disputes arising under other policy provisions "is left to be determined by the court hearing the dispute to find based on the application of its own laws, taking into account the directing language in the policies."

Reviewing these circumstances in this light, and discounting the policies’ various connection to jurisdictions in the United States, and applying British Columbia choice of law principles, Justice Walker concluded that "the policies have the closest and most substantial connection with BC," and therefore BC law governs the coverage dispute presented by the receiver.

In substantiating this decision, Justice Walker stated that given the importance of the Canadian subsidiary, "most of the claims could be expected to arise from Canadian operations," and he stressed that the P&T Ltd. employees’ wage claims are "unique to Canadian operations" and have "no equivalent in Oregon," as a result of which Justice Walker concluded that "the proper law of the policies to determine the carriers’ coverage obligations for these claims is BC law."

He added that the parties "would reasonably have expected BC law to apply to determine the insurers’ coverage obligations."

Discussion

Suffice it to say that I have concerns with Judge Walker’s analysis. He managed to blow right past the fact that all of the acts involved with the formation of the insurance contracts took place in the U.S. and that insurance contracts were formed between a U.S.-domiciled company and U.S.-domiciled insurers, and that the key risks insured against and for which the policy was purchased were U.S.-based.

Justice Walker simply jumps to the conclusion that given the size of the P&T Ltd’s operations, the insurance contracts were primarily designed to protect against Canadian exposures. However, the company that purchased the policy was the parent company, a U.S.-domiciled company whose shares traded on a U.S. securities exchange. Is there any possible doubt that the most important reason the company bought the policy – and the reason the policies cost so much in U.S. currency – is because the company and its directors and officers wanted protection against corporate litigation in U.S. courts under U.S. law?

Of course the policies do provide "worldwide coverage" and, yes, of course substantive local law governs the local claims wherever the claims might arise. But Justice Walker seems to have telescoped the primacy of local law regarding the underlying dispute into a determination that local law should govern questions of policy interpretation, which analytically are two completely different issues.

All of that said, there are a couple of points in Justice Walker’s analysis that do give me pause. In particular, the considerations on which he relied in concluding that principles of dépeçage control the choice of law issue are by no means far-fetched. His consideration of the "law of the most favorable venue" wording in the provisions relating to coverage for punitive and exemplary damages is interesting and raises issues I had not previously considered. He may have a point that this language could be interpreted to suggest that the parties intended the laws of different jurisdictions to apply to different parts of the policy.

Where his analysis goes off track, in my view, is having found that different jurisdictions’ laws may apply to different policy provisions, he concluded both that BC choice of law principles should determine which law should apply, and he applied these BC choice of law principles in a blunderbuss way to conclude that BC law governed interpretation of the policy (see, e.g., his assertion that the likeliest claims to arise under the policies were Canadian claims.)

But the most significant aspect of Justice Walker’s decision is the unmistakable message that if a policy provides "worldwide coverage," the policy not only applies to claims wherever they may arise, but courts in those far flung jurisdictions may push ahead and apply their own local laws to questions of coverage relating to the local claim.

In the increasingly global economy, many businesses have significant operating subsidiaries in many countries. And as the rest of the world become increasingly litigious, too, the possibility of claims arising in these multifarious jurisdictions is increasingly likely. But while the U.S. D&O insurance industry has long noted the increasing possibility of claims arising outside of the U.S., I suspect it may come as a big surprise to many U.S. D&O insurers that local will law will not only govern the local claim itself, but the local court could also determine that local law governs questions of policy coverage for the local claim.

I have no idea what the insurance coverage laws are in vast smorgasbord of countries outside the U.S. Who knows what a court in, say, Vietnam or Slovakia or Gabon might conclude about a U.S-issued D&O insurance policy’s coverage for a local claim? I doubt that many domestic U.S. D&O insurers do either, and I suspect they have little interest in finding out.

On that score, it should be noted that Justice Walker repeatedly recognized the right of the parties to choose the law that would govern the interpretation of the policies, and it was only the absence of any such a provision that allowed him to conclude that BC law should govern.

All of which suggests to me that we may have reached the point where, at least from the carriers’ perspective, it may be time to for U.S.-based D&O insurers to consider the inclusion of a general choice of law clause in their policy. The inclusion of a choice of law clause would have the advantage of predictability and certainty, and it would spare the parties from a post-claim surprise discovery that, for example, the parties reasonably expected that BC law would govern the interpretation of these policies. (I am sure it was news to these carriers to learn that they had "expected" the interpretation of these polices to be governed by the law of British Columbia.)

Given the increasingly global nature both of commerce and of litigation, the inclusion of a choice of law clause arguably could be the reasonable next step in the evolution of the U.S. D&O insurance policy. Many international contracts in many contexts (including the insurance and reinsurance context) as a matter of course specify which jurisdiction’s law should govern the interpretation of the contract. Indeed, the typical D&O policy, with its "worldwide coverage" provision, really is itself an international contract, and to that extent it may be anomalous that U.S. D&O policies often do not have choice of law provisions.

Of course, were general choice of law clauses to be included in D&O insurance policies, the clauses would have to be carefully coordinated with other policy provisions, including in particular the most favorable venue wording relating to coverage for punitive and exemplary damages.

I recognize that both my analysis of Justice Walker’s opinion and my suggestions about the inclusion of choice of law language in U.S. D&O insurance policies could be controversial. I can well imagine D&O professionals who advocate for policyholders arguing that the local law ought to govern policy coverage issues. I can also imagine some insurance professionals objecting that whatever benefit a choice of law clause might produce in the international context, it might produce some unexpected and even unwanted results in the domestic context.

I am very interested in readers’ views, particularly those who may have a perspective different than mine regarding Justice Walker’s opinion and also with respect to my suggestions about choice of law provisions.

Very special thanks to loyal D&O Diary reader Raymond Sieh, whom I just met for the first time at last week’s PLUS International Conference, for providing me with a copy of the opinion.

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Beginning with the corporate scandals earlier in this decade and continuing with the more recent financial meltdown and Ponzi scheme revelations, these has been a widespread push toward corporate governance reform. In some European countries, these developments have been accompanied by the implementation of mechanisms to provide some form of relief to the victims of corporate misconduct.

These legal trends have in turn had a significant impact on the European D&O insurance marketplace, as discussed at length in the November 2009 Advisen report entitled "European D&O Insurance Market to Benefit from Governance and Legal Reforms" (here, $ required).

As discussed in the report, Europe has had its own share of accounting scandals, as a result of which "governments across Europe have passed laws requiring new disclosures, enhanced shareholder protections, and greater transparency." There have also been actual or proposed changes to litigation procedures, many of which represent moves toward the development of various forms of collective action. Though the progression of these changes varies by country, the "clear trend" is toward a "more collective-friendly civil legal system"

As a result of these developments (both the scandals and the legal reform), "the number of shareholder suits filed in European courts is substantially up."

In discussing this European litigation, the report uses its own terminology, and in particular, the report (apparently – the report does not expressly define the term as used in connection with the European litigation) uses the expression "securities suits" to describe both actions initiated by private litigants as well as regulatory enforcement actions.

With this specific use of the phrase "securities suits," the report states that since 2005, "32 large securities suits were filed in European courts against European companies." (The report does not specify what is meant by "large.") Of these 32 "large securities suits," 18 were filed in the first half of 2009 alone. In addition, of the 32, 29 were collective action suits. For cases settled since 2005, the average settlement per case was a "staggering" 117 euros ($155 million).

In addition, European companies have become increasingly susceptible to "securities suits," as the report uses that term, in U.S. courts as well. Claims against European companies doing business in the U.S., particularly those whose shares trade on U.S. securities exchanges, have "mushroomed" in recent years. The number of "securities suits" against European companies increased from 10 in 2005 to 37 in 2008, and to 23 in the first half of 2009.

Many of these "securities suits" against European companies in U.S. courts hare securities class action lawsuits – of the 113 "securities suits" filed against European companies in U.S. courts since 2005 (through mid-2009), 54 are securities class action lawsuits. The remainder of "securities suits" apparently includes enforcement actions, individual lawsuits and derivative actions.

The average settlement of "securities suits" against European companies in U.S. courts during the period 2005 through mid-2009 is 55 million euros ($78 million).

These litigation developments have amplified the risks to corporate directors and officers, and according to the report have affected the perceived need for D&O insurance as well. Most large European companies carry some amount of D&O insurance, although the "perceived level of D&O insurance coverage need varies among countries." Many small to mid-sized European public companies do not purchase D&O insurance at all. This relatively low penetration, together with the changing legal environment that could encourage more companies to purchase D&O insurance, represents a "once-in-a-lifetime growth potential" for D&O insurers.

The report estimates that the European D&O insurance market represents 2008 written premium of 1.37 euros ($2.0 billion), up from about 1.01 billion euros ($1.25 billion) in 2004. By contrast, the Advisen report estimates, the 2008 U.S. D&O insurance marketplace was worth about $6.8 billion.

The European market has grown in recent years at a compound between 2004 and 2008 of about 7.9 percent, but due to improved product take-up rather than to rate increases. The report projects that the European D&O insurance market is likely to continue to grow, though the growth is likely to vary from country to country, commensurate with the countries’ changing levels of legal reform.

The report contains a detailed overview of the specific legal developments in the U.K., German, Netherlands, Italy and France, and also includes summaries of legal developments in Austria, Denmark, Finland, Norway, Spain, Sweden and Switzerland.

The report is interesting and timely, and provides a thorough overview of European legal developments and the way they will impact the European D&O insurance marketplace.

My prior post on the development of collective action procedures in Europe and the contrast of these procedures with the U.S. class action system can be found here. My previous discussion of current D&O insurance issues in Germany can be found here. The state of securities litigation exposures for directors and officers of Japanese and Canadian companies, respectively, can be found here and here.

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There are certain constant issues in the D&O insurance marketplace, but at the same there is always a steady stream of critical issues that emerge and dominate the dialog. In the latest issue of InSights (here) entitled "What to Watch Now in the World of D&O," I take a closer look at the current hot topics affecting the marketplace for D&O insurance.

Bribery Probes and D&O Insurance: Regular readers know that I have written frequently on this blog (most recently here) about the increasing concerns about  the rising number of Foreign Corrupt Practices Act enforcement actions, including possible threats arising from follow on civil actions. The problems that issues may present for D&O insurers is discussed further in an article by Zack Phillips in the November 9, 2009 issue of Business Insurance entitled " Rise in Bribery Probes May Hit D&O Insurers" (here). Special thanks to a loyal readers for sending along a link to this article.

On a related note, Frederick Bourke, Jr., the individual mentioned in the Business Insurance article as having been convicted on criminal FCPA charges, was sentenced yesterday to one year in prison. Refer here for Andrew Longstreth's November 10, 2009 AmLaw Litigation Daily article.

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D&O insurance policyholders typically do not have to provide "fresh warranties" when they renew their policy of the kind they provided when they originally purchased the coverage – that is, they do not have to represent to the insurer that at the time of the renewal they are not aware of any facts or circumstances that could give rise to a claim. However, when policyholders increase their limits of liability at the time of renewal, they often are required to provide "fresh warranties" as to the increased limits, whether in the form of an increased limits application or in a separate warranty letter.

An October 26, 2009 Tenth Circuit opinion (here) illustrates the potential pitfalls for policyholders required to provide fresh warranties for increased limits. In its recent opinion, the Tenth Circuit held that an increased limits warranty exclusion precluded coverage for the defense fees of insured persons that fell within the amount of the increased limits. The Tenth Circuit held that the allegations in a later SEC complaint showed that at the time the policyholders’ representatives signed the letter, individual insured persons had knowledge of accounting improprieties that might (and subsequently did) give rise to claims.

Background

Fisher Imaging carried $5 million of primary D&O insurance, as well as an excess D&O policy providing an additional $2.5 million of insurance. At the time of the company’s April 2002 D&O insurance renewal, the company sought to increase the excess policy’s limits of liability from $2.5 million to $5 million.

In order to obtain this additional $2.5 million of excess coverage, Fisher supplied the excess insurer with a warranty letter signed by the then-CFO and the CEO representing that "no person or entity for whom this insurance is intended has any knowledge of information of any act, error, omission, fact or circumstance which may give rise to a claim which may fall within the scope of the insurance." The warranty letter stated further that it was an "express warranty for all insureds." (This last sentence is capitalized in the original.)

In April 2003, Fisher was sued by its shareholders in two securities class action lawsuits, both of which were later dismissed. In addition, in June 2005, the SEC filed a civil enforcement action against five officers and directors of Fischer. The SEC amended its complaint in May 2008. The amended complaint alleges that from January 2000 through September 2002, the officials had engaged in a scheme to fraudulently inflate the company’s share price by improperly recognizing revenue, misstating financial reports and misleading the company’s outside auditors.

Defense expenses incurred in connection with these actions exhausted the primary $5 million as well as the first $2.5 million of the excess layer. (The primary insurer and the excess insurer advanced these amounts subject to a reservation of rights to challenge these payouts later) However, the excess insurer took the position that the allegations in the SEC’s complaint triggered the exclusionary language in the warranty letter and therefore that it had no obligation to advance defense fees that fell within the "top" $2.5 million layer.

The individual directors and officers who are defendants in the SEC enforcement action filed a separate action against the excess insurer seeking a judicial declaration of coverage for their fees within the top $2.5 million, or in the alternative for a declaration that the excess insurer had a duty to advance defense fees within the layer.

The parties cross moved for summary judgment. The district court held that the allegations in the SEC’s amended complaint triggered the warranty letter exclusion, because "when read together," the SEC complaint and the exclusion show that certain of the individual SEC enforcement action defendants "knew of the wrongful activities at Fischer that could give rise to a claim."

The court granted summary judgment in favor of the insurer and the plaintiffs appealed.

The Tenth Circuit’s Opinion

On appeal, the plaintiffs argued that in reaching its conclusion that the warranty letter exclusion had been triggered, the district court improperly considered matters developed in discovery in the underlying SEC action, and that therefore represented matter "extrinsic" to the question whether the SEC’s amended complaint triggered the exclusion. The Tenth Circuit rejected this argument, stating that "we … confident that the court confined its legal analysis to the allegations in the SEC’s amended complaint."

The plaintiffs next argued that the district court had improperly used an "objective" standard in determining that the exclusion had been triggered – that is, the plaintiffs argued, the district court based its decision on what the plaintiffs (or some of them) must have known, rather than what they subjectively knew. The Tenth Circuit found that the district court properly used the required subjective standard, rather than an improper objective standard. The Tenth Circuit noted:

While the district court did not use the term "subjective knowledge" when it recounted the allegations, its reliance on those allegations about each director’s or officer’s knowledge about and participation in Fischer’s irregular accounting practices establishes that the court properly applied a subjective knowledge standard.

The plaintiffs raised several additional arguments, each of which the Tenth Circuit rejected with a variation on its conclusion that "the district court correctly concluded that the SEC’s claims, when read together, compelled the conclusion that the SEC’s allegations were within the exclusion in the Warranty Letter."

Discussion

Upon initial review, I found a number of things about the Tenth Circuit’s opinion puzzling. The first is that the opinion refers throughout to a warranty "exclusion" – yet there is nothing in the warranty letter language quoted in the Tenth Circuit opinion that would or even could affirmatively precludes coverage. Without any expressly exclusionary language, the excess carrier would lack any contractual basis to disclaim coverage within the top $2.5 million layer, even if there were warranty letter misrepresentation.

In order to try to answer to this puzzle, I tracked down the parties’ appellate briefs on PACER. Upon review of the briefs, it turns out that there was additional, critically important language in the warranty letter that the Tenth Circuit opinion neglects to even quote (a rather astonishing oversight, given that but for this exclusionary language in the warranty letter, there would have and could have been no coverage dispute).

That is, as described in the excess insurers’ appellate brief (here, see page 5), the warranty letter contains additional language, following the warranty statement in which the applicants disclaim the existence of knowledge of any facts or circumstances that may give rise to a claim, providing that "it is agreed that if such knowledge or information exists, any claim arising therefrom…is excluded from the proposed coverage." (The original is in all capital letters.)

So, you wouldn’t know it from the text of the Tenth Circuit’s opinion, but there was critically important exclusionary language in the warranty letter, and that language was in fact the language that the Tenth Circuit was deciding whether or not to apply.

The other thing that puzzled me about the Tenth Circuit’s opinion (and for that matter, the district court’s opinion) is that it seems to make an awful lot out of what are unproven allegations. Merely because the SEC has alleged some things doesn’t mean they are true. Yet the Tenth Circuit repeatedly says the district court properly relied on what the courts themselves both acknowledge were just pleading allegations. Both courts concluded that the mere allegations were enough for the excess insurer to withhold payment of defense fees that fell within the top $2.5 million.

A review of the plaintiffs’ appellate brief (here) did little to help clarify this puzzle. The plaintiffs never quite seem to get around to arguing that just because the SEC has thrown up a bunch of allegations that doesn’t mean that any of individual actually had knowledge of the facts or circumstances that might give rise to a claim at the time the warranty letter was signed.

Indeed, in its brief the excess insurer notes how far away from this argument the plaintiffs stayed, observing that the plaintiffs "understandably have nothing to say about the detailed litany of wrongdoing alleged in the SEC’s Amended Complaint" adding later that the plaintiff "never address this litany of facts." Instead, the plaintiffs seem (to me at least) to get hung up on arcane arguments about whether the objective or subjective standard should apply. It seems to me that only facts are sufficient to satisfy either an objective or a subjective standard, but that mere unproven allegations cannot suffice to satisfy either standard, regardless of which one applies.

This puzzling aspect of the opinion is all the more bewildering (to me at least) given the Tenth Circuit’s conclusion that the "subjective" test is the proper standard to apply. That is, the exclusion could be triggered only if the insured persons had subjective knowledge of the triggering facts. How can a test of subjective knowledge be satisfied by mere allegations rather than upon the proof of actual knowledge? Particularly if, as the Tenth Circuit further held, extrinsic matter is irrelevant -- nothing outside the complaint can be relied upon to show that the allegations are true.

Claimants assert all sorts of bizarre things, but mere allegations alone should not be enough to trigger policy exclusions, particularly an exclusion that is triggered only by what insured persons subjectively knew. Readers who may be able to explain to why I should not be troubled by this aspect of the Tenth Circuit’s decision are strongly encouraged to clarify this for me and other readers using this blog’s comment function. I am particularly interested to know how mere allegations could possibly provide a sufficient basis to trigger an exclusion requiring subjective knowledge of the triggering facts.

One possible explanation does occur to me. It may well be that the plaintiffs did not make the argument that the SEC amended complaint represents mere allegations because they felt they simply couldn’t make an argument premised on the suggestion that they did not have knowledge of some or all of the facts described in the complaint.

Indeed, it probably should be noted in that regard that the company itself had in 2004 voluntarily entered a cease and desist order with the SEC (refer here).Among other things, the agreed order recited that the company, "acting through certain of its officers and personnel," had improperly recognized revenue, overstated inventory, improperly classified expenses, among other things. The plaintiffs may felt under these circumstances that there were limitations on how much they could argue that the SEC’s complaint against them represented "mere allegations."

However, the existence of the cease and desist order might (or then again, might not) explain why the plaintiffs’ may not have raised the argument that the SEC complaint represents mere alletgations; they don’t really explain why the Tenth Circuit concluded that mere pleading allegations were sufficient to trigger the exclusion.

It is worth noting that the circumstances involved in this coverage dispute may be a vestige of the time period in which these events took place. The excess insurer’s warranty letter used provisions that would be unlikely to be used today. Specifically, the excess insurer’s warranty letter was set up so that if any one insured had knowledge of the preclusive facts or circumstances, the top $2.5 million would be unavailable to any insured person, even those without knowledge.

A well-crafted increased limits application or increased limits warranty letter today would likely provide (or the policy to which it referred would provide) that no knowledge of any person would be imputed to any other person. This nonimputation language would operate to preserve coverage for those without knowledge of the preclusive facts, which is clearly a preferable arrangement from the standpoint of insured persons.

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Because private equity firms often place representatives on the boards of their portfolio companies, questions can sometimes arise about the interplay between the private equity firms’ and the portfolio companies’ D&O insurance when claims are asserted against portfolio companies’ boards. All too often, these questions are considered only after claims have emerged. However, the better approach is for these issues to be considered at the outset, when the coverages are first put in place.

An October 19, 2009 article entitled "Getting Your Portfolio D&O Insurance Right (The First Time Around)" (here) by Paul Ferrillo of the Weil Gotschal law firm takes a look at the factors to be considered in connection with structuring both the portfolio companies’ and the private equity firm’s insurance in order to ensure that the policies are appropriately coordinated.

The first question the memo addresses is the issue of how much insurance the portfolio company should carry to ensure that the insurance is sufficient "to insulate the sponsor’s own D&O coverage and more importantly the fund from liability." There are, the memo notes, a host of factors to be considered, including how large the portfolio company is and whether or not the portfolio company under consideration is private or public, but the memo correctly points out that the most important consideration is that the portfolio company’s insurance "should be adequate to insure the portfolio company and its directors and officers against risks related to that company."

As the memo notes, the question of the sufficiency of the portfolio company’s policy limits "is not an area to get caught short" because otherwise the private equity firm’s insurance might be looked to in order to "make up the difference."

The memo notes that in addition to the adequacy of the portfolio company’s limits of liability, the adequacy of the terms and conditions in the portfolio company’s policy must also be considered, since neither all D&O policies nor all D&O carriers "are created equal."

The memo lists a number of particularly important policy features to consider, including: making sure the policy is non-cancelable and that the Side A coverage is non-rescindable; confirming that the Insured vs. Insured exclusion has a broad coverage carve back for claims brought by the bankruptcy trustee, receivers or other bankruptcy constituencies; that the policy has a priority of payments clause; and ensuring that the conduct exclusions are fully severable so that no one’s conduct is imputed to another insured person for purposes of precluding coverage. (I have more to say below about the memo’s comments concerning the conduct exclusions.)

The memo also discusses indemnification issues that can arise when private equity firm’s representatives sit on portfolio companies boards. In a prior post (here), I discussed the potentially conflicting indemnification issues that can arise when private equity firm representatives serve on portfolio company boards, and I reviewed recommendations on how these conflicts may be addressed. The law firm memo also notes that the potentially conflicting indemnification obligations could lead to confusion over the applicability of the private equity firm’s and the portfolio company’s insurance. In particular, the memo raises the concern that if these indemnification issues are not addressed in advance, the portfolio company’s carrier might try to claim that the private equity firm’s insurance should "share" in settlement and litigation expense incurred in connection with a claim against the portfolio company’s board.

In order to prevent an outcome that is not a "result that anyone intended," the memo suggests that the private equity firm’s D&O insurance policy should incorporate wording in its "other insurance clause" stating that with respect to a portfolio company claim against a private equity firm representative on the portfolio company’s board, the portfolio company’s D&O policy is primary and the portfolio company’s policy is excess. The portfolio company’s policy should contain "similar clarifying language."

The memo also suggests that the private equity firm and the portfolio company should enter "separate letter agreements" confirming that the portfolio company is the primary indemnitor for advancement, indemnification and D&O insurance purposes.

Overall, the memo provides a good overview of the issues and raises some important considerations. However, I respectfully disagree with the memo on two points.

The first has to do with what the memo describes as important with respect to the conduct exclusions in the portfolio company’s policy. The memo states that the "fraud and personal profit exclusions should contain ‘in fact’ and/or ‘final adjudication" language.

I disagree with the memo’s suggestion that "in fact" and "final adjudication" wordings may be viewed as somehow equally acceptable, as they most definitely are not.

The "after adjudication" wording requires a judicial determination that the precluded conduct has occurred. The superiority of an adjudication requirement is in fact well-established (see for example my discussion here), as an "in fact" wording potentially could permit a carrier to try to deny coverage even though there has been no determination that the precluded conduct actually took place. Contrary to the suggestion in the memo, the "in fact" wording should be avoided. Indeed, in the current competitive insurance marketplace, there will rarely be a circumstance where any insured should have to accept "in fact" wording in the conduct exclusions.

The second point with which I respectfully disagree is the memo’s repeated suggestion that insurance brokers cannot be relied upon to guide firms with respect to the issues raised in the memo. I agree with the memo’s statement that the task of coordinating private equity firm’s insurance with that of their portfolio companies "is not a task for many ‘generalist’ brokers." However, I disagree with the memo’s later suggestions that brokers may not be a reliable source on the issue of carrier’s claims reputations, or that getting the portfolio company’s insurance right is "not a job to leave" to the insurance broker.

Generalist brokers may not be adequately equipped to address these issues, but there are specialized brokers who have the requisite experience and expertise to deal with these concerns. Of course many companies will also find it reassuring to have their outside counsel involved in the insurance transaction, but experienced insurance professionals with the requisite specialized expertise are eminently qualified to put together insurance programs that coordinate appropriately between private equity firms and their portfolio companies.

UPDATE: After this post's publication, I spoke with Paul Ferrillo, the author of the law firm memo referenced above. To be clear, Paul's comments on insurance brokers were only directed to the "generalist" broker without specific cross-training in Private Equity/Portfolio company D&O issues. Paul notes that he has a great many friends on the brokerage side who add tremendous value to complex D&O insurance transactions involving Private Equity firms and their portfolio companies. His practice pointer here was only that this area is a complex one involving both insurance and legal questions, which all must be melded into a wholistic solution for the client.

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One of the questions insurance professionals have been asking with interest and anxiety since the financial crisis began is whether the economic recession will lead to a "hard market" for insurance (characterized by rising prices and tightening terms and conditions).

Earlier this year, Advisen, the insurance information firm, created a stir by predicting that a hard market for insurance would "begin to set in" as early as mid-2009, and in any event no later than 2010. The earlier Advisen report did, however, note that the current recession could reduce the demand for insurance, which in turn could complicate the insurance cycle’s transition. My post about the prior Advisen report can be found here.

In an updated October20, 2009 study entitled "Planning for 2010: The Recession Will Keep Insurance Premiums Under Pressure" (here), Advisen now reports that "while rates are firming in a few isolated segments of the market," overall, due to falling demand resulting from the recession, insurance buyers "will continue to enjoy favorable pricing in 2010," and "materially higher rate levels most likely will have to wait until 2011."

The insurance cycle is basically a result of the shifting relationship between the demand for and supply of insurance. Prices fall when supply increases faster than demand. In order to track these shifting relationships, the Advisen report uses Gross Domestic Product (GDP) "as a proxy for demand," on the assumption that demand for insurance moves in relation to overall economic activity.

The study notes that historically, when the ratio of the supply of insurance (the insurers’ policyholder surplus) to GDP crosses the 3.2 percent mark, either up or down, "the market changes directions within the next 12 months or so." Part of the reason Advisen had earlier this year made its prediction of an approaching hard market is that the ratio fell to about 3.2 percent at the end of 2008 and continued to fall in the first quarter of 2009. However, the ratio crept back up to 3.27 percent at the end of the first half of 2009. Now, "the market remains unsettled with conflicting forces pushing and pulling on both sides of the tipping point."

The reason for this uneasy equipoise is that the recession is affecting both the supply and the demand sides of the equation. On the supply side, declining investment portfolio values has significantly reduced the insurers’ policyholder surplus. On the other hand, reduced economic activity has resulted in lower demand due to reduced numbers of "exposure units" (such as payroll levels, sales, vehicle units, etc.)

Other factors that have complicated the insurance cycle transition are: lower levels of catastrophe losses during 2009 compared to prior years; heightened competition from wounded market participants; the entry of new insurance capacity; and the insurers’ release of redundant loss reserves from prior years. Some of these factors could disappear (for example, catastrophe claims could emerge with little advance warning), or are less likely to be a factor going forward – in particular, loss reserve redundancies "now have been almost fully harvested," which eliminates insurers’ "cushion against adverse developments" and "could contribute to upward pressure on rates in 2010 and beyond."

Even if the recession may have ended as a matter of technical economic analysis, its effects are still being widely felt and the impacts from recovery "will be uneven, leading to further complexity and uncertainty" with respect to capacity and pricing. While these factors will continue to complicate the insurance cycle transition and "delayed the hard market," the shifting elements of the supply and demand equation "favor a modest increase in insurance demand by the end of 2010" – though "materially higher rate levels most likely will have to wait until 2011."

In the meantime, other than in certain areas, commercial insurance rates "on average continue to drift downward, though at a much reduced rate compared to a year ago." With respect to D&O insurance, financial sector premiums have "increased sharply" and financially stressed or highly leveraged companies "are likely to see higher premiums and some may have trouble finding adequate coverage." However other companies can expect to see premiums continue to fall into 2010, though "at a much slower pace."

Even at the time of Advisen’s earlier report, I had commented that "if there is going to be a hard market, its arrival could be more delayed than the report suggests." The more recent report seems consistent with my prior view that a hard insurance market could prove to be a long time coming. At this point, I don’t think I have any better sense of when it might arrive. I do agree that the uneven and gradual nature of the economic recovery could further delay the cycle transition. Unanticipated events (such as significant natural catastrophes) could intervene to accelerate the change, but absent those kinds of developments, the prospects for a market change anytime soon seem remote.

In any event, at 11 am EDT on October 22, 2009, Advisen will be hosting a free one-hour webinar on the State of the Insurance Market and the 2010. Registration for the webinar can be found here.

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Stanford Financial Group’s D&O insurer may advance the individual directors’ and officers’ defense expenses without violating the court’s receivership order, according to an October 9, 2009 ruling by Northern District of Texas Judge David Godbey. A copy of Judge Godbey’s ruling can be found here.

As detailed in a prior post (here), the insurer had been prepared to begin advancing defense expenses of Stanford Group’s former CFO, Laura Pendergest-Holt, subject to a reservation of its rights to later deny coverage under the policy if circumstances should warrant. However, before the insurer began advancing these amounts, the Stanford group receiver had notified the receiver that if the insurer advanced Pendergest-Holt’s defense expenses, the receiver would seek to have the insurer held in contempt of court for violating the court’s receivership and asset freeze orders.

The receiver asserted that the proceeds of the D&O insurance policies are "receivership assets" within the meaning of Judge Godbey’s prior receivership and asset freeze orders. The receiver also argued that his right to the proceeds "supersedes" the rights of insureds under the policy.

Pendergest-Holt filed a motion in the SEC enforcement proceeding (here) seeking a judicial clarification that the receivership order does not apply to the D&O policy proceeds, and alternatively seeking authorization for the disbursement of the proceeds for payment of her defense expense.

The insurer itself had also inquired of the court whether it could advance the defense expenses without "running afoul" of the receivership order. However, the insurer, which has separately filed an action seeking a judicial declaration that the Stanford receivership is not entitled to payment of claims as a result of the operation of policy exclusions, did not request the court in the SEC enforcement proceeding to decide whether or to what extent any insured is entitled to coverage—it sought only to determine whether the receivership order barred it from advancing the individuals’ defense fees.

In his October 9 ruling, Judge Godbey concluded that he did not need to determine whether or not the proceeds were receivership assets, because he concluded that he would exercise "equitable discretion" to permit the payment of defense costs "even if the proceeds were part of the receivership estate."

In deciding to exercise his discretion to allow the proceeds to be advanced for defense expenses, he noted that "there is no argument that the insurance proceeds are potentially tainted by fraud" and therefore "the Court has not duty to preserve them as such." As for the possibility that the insurance premiums might have been paid with "stolen money," he noted that while this might be "unjust and regrettable," that fact "would not entitle victims to proceeds of policies intended to pay defense costs."

With respect to the receiver’s argument that allowing policy proceeds to fund the individuals’ defense expense would "decrease the coverage dollars eventually available for distribution," Judge Godbey found that "the possibility that the D&O proceeds might one day be paid into the receivership does not justify denying the directors’ and officers’ claims." The judge noted that the receiver "has not yet tendered any claims against the Stanford entities to [the insurer] for a defense," noting further that even if it had, "it is not at all clear" that the insurer would ever pay a claim into the receivership, owing to the insurer’s policy defenses.

Finally, Judge Godbey found that the "interests of fairness" justify allowing the individuals to access the insurance proceeds. The receivership’s potential claims are "speculative" while the individuals "expected that D&O proceeds would afford a defense" and the "potential harm to them if denied is not speculative but real and immediate: they might be unable to defense themselves."

Judge Godbey emphasized that in his ruling that his prior orders the insurer from disbursing policy proceeds to fund the individuals’ defense, he was not holding that any defendant "is entitled to have its defense costs paid by D&O proceeds." Moreover, Judge Godbey emphasized that his October 9 ruling does not authorize the insurer "to pay any claims other than defense costs."

Though Judge Godbey ruled only on Pendergest-Holt’s motion, his ruling expressly "extends to any covered officer or director whose claim is approved" by the insurer. Judge Godbey’s ruling seemingly applies to R. Allen Stanford himself, at least to the extent that the ruling represents a determination that the court’s prior receivership orders are no bar to the insurer advancing defense costs.

Whether the insurer will in fact advance Allen Stanford’s defense expenses may be yet to be determined, notwithstanding the October 9 ruling that the receivership order is no bar. An October 9, 2009 Bloomberg article (here) presumes that as a result of Judge Godbey’s ruling, Stanford is now entitled to have his attorneys’ fees advanced. Indeed, absent a judicial "determination" that Stanford in fact engaged in excluded misconduct, the basis on which the insurer might withhold advancement of Stanford’s defense expenses is not immediately apparent, notwithstanding the seriousness of the allegations against him.

The problem for everyone involved is the sheer number of persons who will seek to have their defense fees paid by the insurance and the extent of the collective defense expense. According to the Bloomberg article, as many as 60 Stanford officials are seeking to use the D&O insurance proceeds to pay their legal bills. Moreover, many of these individuals are involved in numerous civil and criminal proceedings.

The total amount of D&O insurance available is not entirely clear from the published reports. The Bloomberg article variously reports that the total insurance limits are "as much as $50 million" and "as much as $90 million" – kind of a big swing on a rather important detail. But the potential for defense expenses in catastrophic claims to substantial erode or even exhaust insurance programs of a similar magnitude has already been demonstrated in other claims (refer for example here).

Given the seriousness of the allegations and the multiplicity of proceeding involved, the various individuals’ collective defense expenses could quickly erode the available limits, particularly if, as seems possible, Stanford himself accesses the policy proceeds for his defense expenses.

It is worth noting that Judge Godbey exercised his discretion to allow the proceeds to be advanced toward the defense expenses, notwithstanding the Stanford entities’ potential claims, even though this policy reportedly lacked a "priority of payments" provision, which would have given the individual defendants priority to the policy proceeds over the entity, as a matter of policy language. As discussed in an October 4, 2009 Business Insurance article (here), this type of provision is now standard in most D&O insurance policies, and might have helped sort out this dispute, although in the end the outcome apparently would have been no different.

Special thanks to William Schreiner of the Zuckerman Spaeder law firm for providing me with a copy of Judge Godbey’s October 9 ruling.

No D&O Policy Coverage Where Claim Made Only Against the Company: In an October 8, 2009 opinion (here), the First Circuit held that a D&O insurance policy does not cover the settlement of a disability discrimination claim that did not name any individual directors and officers as defendants.

The Medical Mutual Insurance Company of Maine had been sued in an administrative proceeding by a former company executive who claimed that the company had discriminated against him due to his stroke-related disability. The administrative proceeding resulted in a "right to sue" letter, pursuant to which the former executive initiated a federal court discrimination lawsuit. Both the administrative complaint and the federal complaint named only the company itself as a defendant.

The company settled the lawsuit and sought coverage under the D&O insurance policy for $325,000 of the settlement amount. The D&O insurer denied coverage under its policy, arguing that because there had been no claim made against an individual director or officer, there was no coverage for the settlement under the policy’s "corporate reimbursement" coverage. (The opinion explains in footnote 3 that while the policy also separately provided "entity coverage" for "securities claims," the discrimination complaint was not a securities claim and accordingly the policy’s separate entity coverage provisions were not implicated.)

In an October 8 opinion written by Judge Bruce Selya, the First Circuit held that the company’s argument that the policy’s coverage extended to claims in which directors and officers were not named as defendants "would if accepted transmogrify D&O policies into comprehensive corporate liability policies," and that "such a transmogrification is contrary to both the letter and the spirit of the D&O policy at issue."

The company had argued that the Policy’s claims made requirement had been satisfied because the underlying discrimination complaint consisted "largely of allegations of misconduct on the part of the directors and officers." The First Circuit held that "no matter what conduct the complaint describes, it is not a claim ‘made against’ any of the directors and officers."

The court went on to note that the policy’s separate requirements of both allegations of wrongful acts and for claims against insured persons "are complementary requirements and allegations of wrongful acts, without more, do not satisfy both."

The First Circuit’s opinion is arguably unremarkable, as D&O policies clearly and separately require both allegations of wrongful acts and claims to be made against insured persons.

The only puzzling thing to me about this case is why there was a D&O insurance dispute at all. The more natural place for the company to have looked for coverage for a claim like this is an Employment Practices Liability (EPL) insurance policy. EPL policies are designed to provide coverage for employment-related discrimination claims and generally provide coverage for claims against the insured organization.

Because I was curious, I ran down the parties’ appellate briefs on PACER. As it turns out, and as might have been predicted, the insured company did indeed also submit this claim to its EPL insurer.

As reflected in the D&O insurer’s appellate brief (here, at pages 4-6), not only did the EPL insurer provide the company with a defense for the underlying claim but it also paid $225,000 toward a total settlement amount of $500,000. The remaining $325,000 portion of the settlement amount for which the company sought coverage under the D&O policy represented the amount the company paid in resolution of the former executive’s unpaid contractual severance and benefits, for which the EPL carrier denied coverage under its policy.

So – that explains why this company was trying to stick what is rather obviously an EPL claim into the D&O policy, because there was a portion of the underlying EPL claim settlement for which the EPL policy did not provide coverage.

In any event, congratulations to my friend and former colleague Leslie Ahari, who represented the insurer in this action.

An October 12, 2009 Law.com article discussing the opinion can be found here. Special thanks to alert reader Marty Fox for providing me with a link to the Law.com article.

The Transmogrifier: For reasons unrelated to the merits or even the issues involved, the First Circuit’s opinion is one of my new favorites -- it is the first judicial opinion of which I am aware using the words "transmogrify" and "transmogrification." (Judge Selya, the opinion’s author, has a well-established reputation for using flamboyant and occasionally obscure language in his opinions.)

The word "transmogrify" in its various formulations was forever immortalized in the Calvin and Hobbes comic strip, in which Calvin turned an empty cardboard box into a "transmogrifier," capable of changing a person into "whatever you’d like to be."

There is a truly wonderful website here dedicated exclusively to the Calvin and Hobbes transmogrifier comic strips. And the excuse to be able to link here to the Transmogrifier site is more than enough justification for discussing the First Circuit opinion above.

Please click through to the site and enjoy the comic strips. They will make you smile. You too could consider turning yourself into a "500-story gastropod, a slug the size of the Chrysler Building." However, do keep in mind, as Calvin reminded Hobbes, that "transmogrification is a new technology."

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One of the recurring D&O insurance issues is the question of policy coverage for additional acquisition consideration paid to an acquired companies’ shareholders – so-called "bump up" claims. In an interesting and colorfully written September 28, 2009 opinion (here) that insurers undoubtedly will cite profusely in future disputes of this kind, District of Massachusetts Judge Nancy Gertner held that Genzyme Corporation’s D&O insurance policy did not cover amounts Genzyme paid to settle the claims of individuals who asserted they had received inadequate consideration in an exchange for their tracking shares of an internal Genzyme division.

Background

From 1993 to 2003, Genzyme’s capital structure included "tracking stock" to track the performance of separate business units within the company. In May 2003, Genzyme’s board decided to eliminate the tracking stocks, and the company announced that it would exchange the business units’ tracking stock for a certain number of the company’s General Division’s shares.

The ensuing exchange "proved to be unpopular among many Biosurgery Division shareholders," who subsequently initiated a securities class action lawsuit against Genzyme and certain of its directors and officers. The Biosurgery Division shareholders alleged that the defendants had schemed to depress the Division’s tracking stock so that Genzyme could fold the Biosurgery Division into the General Division at an exchange rate favorable to General Division shareholders. In August 2007, Genzyme agreed to settle the Biosurgery Division shareholders’ claim for $64 million. More detailed background regarding the lawsuit can be found here.

Genzyme sought to recover part of this settlement amount from its D&O insurer. The insurer denied coverage on two grounds: (1) that the settlement did not represent insurable "loss" under the policy; and (2) that coverage was precluded by the policy’s "bump up" exclusion. Genzyme initiated coverage litigation. The D&O insurer moved to dismiss.

The September 28, 2009 Opinion

Judge Gertner opened her opinion with an assessment of the "plethora of cases" on which the D&O insurer sought to rely to argue that "an insured does not incur insurable loss when she is merely forced to disgorge money or other property to which she is not entitled." Judge Gertner noted that "this legal principle is undeniably correct and would almost certainly be adapted by a Massachusetts court."

Judge Gertner then made the first of the several vivid commentaries that characterize her opinion, when she noted that

A thief should not be able to claim the return of stolen property as an insurable loss. Similarly, an individual who breaches her contract and then is forced to pay damages should not be able to seek indemnification under an insurance policy. If I pay only $100for an item for which I promised to pay $200, and I am later ordered by a court to pay the additional $100, I should not be able to claim the additional $100 as an insurable loss. Had I paid the full $200 due up front, then clearly no part of the $200 would constitute loss covered by insurance. The dilatory nature of my obligatory payment should not transform it into an insurable event.

Genzyme sought to distinguish the referenced case law by arguing that it had received no benefit to which it was not entitled or that could be disgorged. Judge Gertner agreed, noting that the company had merely reorganized its capital and issued additional shares. But while Genzyme itself did not benefit, its shareholders "surely did" benefit from the reduced exchange ratio, and the class action was "meant to redress the imbalance."

As a result of these circumstances, Judge Gertner found, this case "does not fit comfortably within the existing case law holding that the mere return of an ill-gotten gain was uninsurable." She expressly rejected the insurer’s "attempt to force this case into the existing case law."

Having determined that the existing case law was inapposite, she proceeded to address defendants’ motion based her own analysis of the question presented, which she stated to be as follow: "When a corporate pays a settlement to resolve a claim that it benefitted one group of shareholders at the expense of another group of shareholders, is this settlement payment an insurable loss?" The answer to this question, she found, "must undoubtedly be ‘no.’"

To explain this conclusion, Judge Gertner resorted to a "somewhat strained – but one hopes enlightening – hypothetical." In her hypothetical, a father and his two sons, Daniel and Eli, are in a restaurant and have ordered a singled milkshake divided into two cups. The father redistributes the milkshake between the cups in a way that leaves Daniel with two-thirds of the milkshake and Eli with one third. The father, she noted, would be expected equalize the distribution, not "to turn to the restaurant owner and demand that he provide more milkshake to make up the difference."

Drawing upon this hypothetical, she found that the lawsuit settlement had merely "recalibrated the division" in the share exchange by giving the Biosurgery Division shareholders additional cash in place of the additional shares to which they claimed they were entitled. Genzyme should not, she said, be able to demand indemnification from the insurer for what is in effect a share redistribution.

If Genzyme’s interpretation of the policy were correct, she found, "a corporation merely need issue several classes of shares, cancel one class in an arguably unfair way, and then demand that the insurer pick up the tab." She rejected this possibility noting that the policy "should not be read in a way that produces absurd results."

Judge Gertner then turned to the insurer’s alternative argument that there was no coverage under the policy for the settlement because of the policy’s "inadequate consideration" or "bump up" exclusion, which provides that the carrier is not liable for "the actual or proposed payment by any Insured Organization of allegedly inadequate consideration in connection with its purchase of securities issued by any Insured Organization." Genzyme argued that the exclusion did not apply because the share exchange did not involve a "purchase" of securities, but rather the mere exchange of one class of securities for another.

After reviewing dictionary definitions, Judge Gertner concluded that the share exchange was "unambiguously a ‘purchase’ within the natural and ordinary meaning of the word." She also found that Genzyme sought coverage under a policy provision applicable only to a "securities claim," defined inter alia as the "purchase or sale of securities." Genzyme, she noted, was contending that the share exchange was a "purchase" for purposes of relying upon the policy’s definition of securities claim, yet did not explain why the same word should have a different meaning in a different policy provision.

Judge Gertner rejected Genzyme’s further argument that even if Genzyme itself no claim in its own right under the policy, there would still be coverage for the settlement under the policy’s separate insuring clause providing reimbursement for Genzyme’s indemnification of its directors and officers.

Judge Gertner found that "it makes little sense to allow a corporation to sidestep coverage limitations in its insurance policy through the simple expedient of claiming that a settlement payment was made to indemnify its directors and officers." She noted that a contrary holding could "encourage fraud" and "chicanery," as otherwise a corporation could use calculated indemnification resolutions to try to create coverage for otherwise noncovered claims.

Discussion

Judge Gertner’s opinion is not only highly readable and even entertaining, it is also potentially significant, for a number of reasons.

First, Judge Gertner made it clear that she was not relying on prior case law in reaching her decision. As a result, her opinion potentially represents a new line of analysis in connection with the perennial questions about coverage under the D&O policy for "additional consideration" claims. In particular, her analysis does not depend on whether or not the payment for which coverage was sought was "restitutionary." Rather her analysis turned on whether the insurer could fairly be asked to pay for what was effectively a redistribution or "recalibration."

At a minimum, this line of analysis could give insurers disputing coverage for "bump up" settlements an additional ground on which to base their position, arguably without even having to get into the question whether the payment in dispute was "restitutionary." Insurers instead (or perhaps alternatively) will strain to rely on Judge Gertner’s milkshake hypothetical.

Second, and perhaps more significantly, Judge Gertner did not base her decision on the bump up exclusion alone, although she did grant the motion in the alternative based on the exclusion. The significance of the fact that she separately and independently granted the motion to dismiss on the ground that the settlement is not an insurable "loss" is that even today many policies do not contain a bump up exclusion. Indeed, over the years, many of the "additional consideration" coverage disputes that have arisen have involved policies lacking such exclusions. Judge Gertner’s reasoning could be particularly influential in future "additional consideration" disputes involving policies without bump up exclusions.

Third, even though her opinion did not rely on the prior case law holding that restitutionary payments are uninsurable, her detailed elaboration of the intellectual basis for the principles behind the case law will undoubtedly add weight (and color) to legal arguments relying on these cases.

Fourth, the decision is also significant for its interpretation and application of the bump up exclusion. As I noted in a prior post (here), these exclusions are still relatively new, vary widely, and generally have not been subject to extensive judicial scrutiny. There is still relatively little case law interpreting bump up exclusions. Judge Gertner’s enforcement of the exclusion here, particularly her conclusion that the share exchange was a "purchase" within the exclusion’s meaning, helps illuminate how these exclusions operate and how they will apply.

Finally, Judge Gertner’s opinion may be particularly noteworthy because of her willingness to dispense with prior case law formulas and to base her decision instead on a careful consideration of the underlying transaction and facts. However, I expect that not everyone is going to be equally impressed with her milkshake hypothetical. Even those inclined to cheer Judge Gertner’s opinion here should reflect on the possibility that other judges, perhaps lacking Judge Gertner’s intellectual rigor, might unburden themselves of their own hypotheticals that may or may not have anything to do with the parties’ reasonable expectations of how the policy should operate.

In any event, insurers undoubtedly will find much to like in Judge Gertner’s opinion, which is not only highly literate but highly quotable. Her colorful phrases will undoubtedly be featured heavily in insurers’ future legal briefs both on bump up claims and with respect to questions regarding restitutionary payments. The only things that may undercut insurers’ attempts to rely on the Genzyme decision are the somewhat unusual facts involved in the case. Those seeking coverage will certainly try to argue that Judge Gertner’s "redistribution" or "recalibration" analysis is restricted to the specific and unusal circumstances of the Genzyme case.

A September 29, 2009 memo by the Wiley Rein law firm summarizing the opinion can be found here. Wiley Rein represented the D&O insurer in the Genzyme coverage dispute.

Special thanks to the several loyal readers who sent me copies of the Genzyme opinion.

All That, and She’s A Fellow Blogger, Too: Readers curious about Judge Gertner’s willingness to express herself so freely in a judicial opinion may be interested to know that in addition to being a federal judge, she is also a blogger. According to a Boston Globe profile (here), she began blogging because she determined with respect to blogs (correctly in my view), that "if this is where people are getting information, this is where to be." She also noted, in an observation to which every blogger and would-be blogger will relate, that the hardest part about blogging may be finding time to blog.

She apparently has had found little blogging time lately, because there have been relatively few recent entries by any of the contributing authors on the site for which she has been blogging, the Convictions blog on the Slate website (here). (Believe me, Judge Gernter, I know all about the way a pesky day job can interfere with important blogging activities.)

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On September 9, 2009, Towers Perrin released its report of the firm’s 2008 Survey of Directors and Officers Liability Insurance Purchasing Trends, which can be accessed here. Towers Perrin’s anticipated annual report again this year will undoubtedly be widely read throughout the D&O insurance industry. The report is a good resource and it is full of useful and interesting information.

Because the Report is so widely read, I think it is very important to highlight some specific issues about  the report. As I noted in connection with the 2007 report (here), the survey report is subject to some very important limitations that may not always be fully appreciated or understood.

In my view, the most significant limitation is one that is duly noted in the final two sentences of the Report section headed "Statistical Terms Used in This Report." As the Report states, the Report is the product of a survey, which means that the data in the Report are drawn from a "non-probability sample." That is, participants "choose – or are selected" to participate, and therefore the sample "is not random." Most importantly, because "not all potential respondents are likely to participate, survey biases must be considered when interpreting results."

It is the danger that this last point – the possibility that the reported results reflect "survey biases" – that most concerns me. In particular, the reference to the possibility that the survey respondents were "selected" is particularly relevant.

Specifically, the broker rankings section of the Report reveals that fully 95.2% of all survey responses came from the clients of just four brokerage firms. The same four firms also dominated the 2007 survey results, but the 2008 results reflect an even greater concentration, as the four firm’s clients represented "only " 88% of the survey respondents in the 2007 survey. In the 2008 survey, only 4.8% of all respondents are clients of firms other than the four brokerages. Indeed, clients of the three global insurance carriers represented just 1.8% of the respondents.

These observations should not be taken as a criticism of these four survey-predominating brokerages. I will stipulate that they are in fact strong and significant industry participants. But no informed person actually thinks they are the four largest D&O brokers in the country. They are undeniably the leading firms in getting their clients to complete the Towers Perrin survey. Again, no criticism here; I salute their enterprising spirit in achieving this result. However, no one should confuse the survey "ranking" with an actual market share ranking, nor could anyone fairly attempt to use the survey results to try to create that impression.

I emphasize this aspect of the Report because the survey bias in the broker participation population has pervasive effects throughout the entire report. Indeed, given that the pool of actual survey respondents for all practical purposes represents the clientele of those four brokerage firms, the Report fairly might be characterized as a description of the purchasing patterns of the clients of those four firms, rather than of the marketplace as a whole.

However, the Report itself does not address whether or not this rather categorical "skew" in the survey response population affects the other reported results, although it pretty obviously could significantly affect many of the other observations in the report. For example, the Report’s attempt to rank carriers by policy count and premium could simply be a reflection of the predilections of the four firms. The same is true with respect to such issues as respondents’ decision whether to purchase Side A insurance or IDL insurance.

There are other limitations arising from the characteristics of the respondents. Many of the respondents are very small.—nearly 40% reported assets under $6 million. Nearly 70% of the respondents had under 100 employees.

Another perhaps more significant concern with the 2008 Report is that the survey participants completed the survey during the third quarter of 2008. Not only does that mean the data are a year old, but also the survey results may fail to reflect the enormous changes in both the global economy and in the insurance marketplace during the last twelve months. Thus, there is some risk that the survey results, to whatever extent they fully and accurately reflect marketplace conditions of a year ago, may not reflect current conditions, given the enormous changes since the survey was conducted.

In addition, the Report also makes numerous year over year comparisons, noting changes between the results of the 2007 survey and the results of the 2008 survey. The difficulty with these comparisons is that there is no way of knowing whether or not the differences in the survey results are simply the result of a different mix in survey respondents, rather than a change in the underlying circumstances. To be sure, the Report does several times work hard to provide comparisons showing the results reported by repeat survey respondents. But there are numerous comparisons throughout the Report that are not so limited.

With respect to the concern noted above about the concentration of survey respondents in the portfolios of just four brokerage firms, it is a fair observation that the survey is open to all. If survey participation were more widespread, many of the concerns noted above might be alleviated. However, the opposite appears be happening, as participation by other brokerage firms is clearly declining, for reasons that might well be surmised.

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

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Each fall for the last three years I have taken a look at the current trends and hot topics in the world of D&O. There are of course the perennial topics that always remain important. However, this overview is intended to address the most significant concerns of current interest for D&O insurance professionals and their clients. My list of the current issues to watch is set out below.

Will Rising Corporate Bankruptcies Produce Increased D&O Claims?

According to the Administrative Office of the U. S. Courts (refer here), the number of business-related bankruptcies increased 63% (to 55,021 from 33,822) during the year ended June 30, 2009. Although there are some encouraging signs that the overall economy may be beginning to recover, significant numbers of individual companies could continue to face the risk of bankruptcy for some time to come.

Among other problems associated with bankruptcy filings is the risk of increased claims against officials at the bankrupt firms. For example, in its 2008 year end report on securities litigation activity, Advisen noted that since 1995, roughly 35 percent of the large public companies (defined as having assets of over $250 million in 2008 dollars) that filed for bankruptcy also sustained securities class action lawsuits against their directors and officers. During 2007 and 2008, the percentage increased to 77 percent. The directors and officers of private companies also face a heightened claims exposure when their companies file for bankruptcy.

Bankruptcy associated-claims present a host of complications, not least of which is the intricate (and sometimes problematic) way that D&O insurance policies respond in the bankruptcy context. One recent development illustrating the difficulties that can arise in the bankruptcy context was the July 2009 decision in the Visitalk case (about which refer here), in which the Ninth Circuit upheld the carriers’ denial of coverage for a lawsuit brought by a company as debtor in possession against former directors and officers of the company, as a result of the policies’ insured vs. insured exclusion.

These kinds of complications underscore the need for D&O insurance policies to be closely scrutinized for their ability both to withstand and to respond to claims arising in the context of bankruptcy.

One final concern is that the rising tide of corporate bankruptcies could trigger increased losses under Excess Side A insurance that many companies now carry. This possibility is one of several factors, many of which that are discussed below, that could represent a changing environment for carriers offering Excess Side A insurance. The increased number of bankruptcies in any event further reinforces the proposition that Excess Side A insurance is an indispensible part of a complete D&O insurance program for any corporate insured, whether public or private.

Will the Growing Number of Bank Failures Produce a Wave of Failed Bank Litigation?

The number of 2009 year to date failed banks is now up to 89 (as of September 4, 2009, about which refer here), and the total number of bank failures since January 1, 2008, is up to 114. Alarmist commentators have made predictions that as many as 1,000 banks could fail by the end of 2010, as discussed here. Whether or not the number of bank closures will come anywhere near that level, it is clear that we are in the midst of the most significant wave of bank failures since the S&L crisis.

The question remains whether this time around we will see the same level of litigation activity as we saw during the last failed bank wave. Somewhat surprisingly, so far the FDIC has initiated relatively little litigation to try to recoup its losses from the directors and officers of the failed financial institutions. However, for now the FDIC is preoccupied dealing with further bank closures. And even during the S&L crisis, the FDIC and the other regulatory agencies usually did not act until statutes of limitations were just about to expire. There could yet be another round of failed bank litigation, in a 21^st Century edition.

Private litigants might also be expected to get in the act -- for example, investors who lost their entire investment when a bank closes might well be expected to pursue claims. There has been a certain amount of that (refer here). There has also been some securities class action litigation activity involving failed banks whose shares were publicly traded. Of the 25 banks that failed in 2008, six of them are involved in securities class action litigation, even though only 11 of them were publicly traded.

However, the securities class action litigation involving the failed banks has not fared particularly well so far. For example, in the Downey Financial securities class action lawsuit (about which refer here), the district court recently granted the renewed motion to dismiss following the plaintiffs’ attempt to amend their complaint to try to remedy the pleading defects noted in the initial dismissal without prejudice. In addition, in the Fremont General securities lawsuit (refer here), the court also granted the defendants’ motion to dismiss, albeit with leave to amend.

These early returns potentially could be discouraging some potential litigants. Nevertheless, if for no other reason than the fact that there was so much failed bank litigation last time around, it seems likely that when all is said and done, the growing number of bank failures will at some point lead to an extended round of failed bank litigation.

Whether or the failed bank litigation ultimately emerges, the D&O insurers have responded defensively to the wave of bank failures. Many financial institutions, including even smaller community banks, are facing significantly more challenging circumstances when trying to renew their D&O insurance. Many banks find that they can obtain coverage, if at all, at significantly greater cost for significantly restricted terms and conditions, and in many instances with significant new limitations such as reduced limits of liability or the addition of additional exclusions, such as a regulatory exclusion. The wave of failed banks has already had a significant impact in the D&O insurance marketplace.

Will the Rising Number of Derivative Lawsuit Mega Settlements Mean Significant Excess Side A Losses?

Within the last several years, there have been a rising number of unprecedented mega settlements in shareholders’ derivative lawsuits, particularly during the last 12 to 24 months. These massive derivative lawsuit settlements include the $900 million UnitedHealth Group options backdating settlement (refer here); the $118 Broadcom options backdating settlement (refer here); and the $115 AIG settlement (refer here).

One consequence of this outbreak of massive derivative lawsuit settlements is that now for the first time Excess Side A carriers are being called upon to contribute significantly toward settlement outside of the insolvency context. The recent Broadcom settlement, in which the Excess Side A insurers collectively contributed $40 million to settlement, appears to represent a milestone development in that regard. While there may well have been prior occasions on which Excess Side A insurance contributed toward settlement outside of insolvency, the Broadcom settlement is by far the most public example. Based on the reactions I have heard, the Broadcom settlement has been a wake up call of sorts for many players throughout the D&O industry.

Among other things, the Broadcom settlement underscores the value for companies and their directors and officers of the Excess Side A product, which, along with the insolvency related considerations noted above, should further encourage policyholder take up of this product. As also noted above, Excess Side A protection increasingly will become a standard part of any well designed D&O insurance program.

The Broadcom settlement also represents a significant development for D&O insurers as well, who until now have enjoyed the opportunity to offer Excess Side A insurance in a relatively low loss cost environment, particularly outside the insolvency context. The Broadcom settlement highlights the potential for Excess Side A insurers to sustain significant claims losses on this product, even outside of the insolvency context. The increasing incidence of mega derivative lawsuit settlements underscores the growing possibility of these kinds of losses.

Another significant side effect of the Broadcom settlement is that the plaintiffs’ lawyers clearly will now have developed an appreciation of the value of presenting claims that trigger the Excess Side A coverage. The question arises whether they might now attempt to craft claims for the express purposes of accessing the Excess Side A limits. The attempt to pursue this strategy would face considerable challenges – derivative lawsuits, for example, are subject to formidable defenses, including the demand requirement and the business judgment rule defense. Nevertheless, the possibility of claims targeted expressly at the Excess Side A limits is a consideration that should not simply be disregarded.

Will Securities Lawsuit Filings Return to Historical Levels?

As discussed in a prior post (here), securities class action lawsuit filings dropped during the second quarter of 2009. This decline was largely due to the low filing activity during May (when there were only 11 new securities class action lawsuits) and during June (when there were only six new securities lawsuits), compared to historical monthly filing levels in the range of 15 to 20 new lawsuits a month.

At least to this point in the third quarter, it seems as if the second quarter filing decline was just a temporary dip that has already ended. There were at least 20 new securities class action lawsuits in July, and at least 17 in August, both of which monthly filing levels are well within historical norms.

Another interesting attribute of the most recent lawsuit filings is that so far the third quarter filings are not nearly as concentrated in the financial sector. During the first half of the year, about two-thirds of the securities class action lawsuit filings involved financial companies. However, of the 37 securities lawsuits filed in July and August, only about 13 (or roughly a third) involved financial institutions. In other words the proportion of lawsuits filed against financial companies to lawsuits filed against nonfinancial companies seems to be completely reversed from the first half of the year.

The other interesting thing about the third quarter filings is the extent to which the cases involve proposed class period cutoff dates that are well in the past, sometimes by as much as a year or more prior to the actual filing date. As I have previously noted on this blog (most recently here), these belated filings suggest that while the plaintiffs lawyers were scrambling to file subprime and credit crisis-related lawsuit against financial companies in the first part of the year, they were also developing a backlog of other cases that they are now working off.

All signs indicate that by the end of this year, securities class action filing levels will likely have returned to historical levels after the brief and apparently temporary decline in the second quarter. The concentration of filings in the financial sector also seems to be abating, with distribution of filings by industry starting to look more like historical norms.

How are Plaintiffs Faring in the Subprime and Credit Crisis-Related Securities Lawsuit?

We are now more than two and a half years into the subprime and credit crisis-related litigation wave, yet in many respects the cases are still only in their earliest stages. But there have been a number of recent significant developments suggesting that the evolving subprime litigation wave recently may have passed a significant milestone, and that it could be an appropriate time to take a closer look at the status of the subprime and credit crisis cases. For that reason, I will be publishing a post within the next few days providing a detailed status report on the litigation wave. I will update this post with a link when the status report is available. UPDATE: My September 8, 2009 status report on the subprime and credit crisis related litgation can be found here.

In the meantime, though the wave is still in its early stages, it is possible to make a number of generalizations. First, it seems like the defendants again have the upper hand at the motion to dismiss stage. Among other things, the Eighth Circuit’s recent decision affirming the district court’s dismissal in the NovaStar Financial case (about which refer here) represents a significant victory for defendants. The Downey Financial dismissal, discussed above in connection with the failed banks is another example. The recent dismissals in the Citigroup subprime-related derivative lawsuit (refer here) and Citigroup ERISA lawsuit (refer here, scroll down) also suggest that plaintiffs may be faring poorly in those cases as well.

On the other hand, there have also been some significant recent settlements suggesting that if the plaintiffs can survive motions to dismiss in these cases, the cost of settlement can be significant. Along those lines, the recent $32 million settlement in the RAIT Financial case (refer here) and the $22 million settlement in the Accredited Home Builders case (refer here) illustrate how costly it can be to try to settle cases that survive motions to dismiss.

Two equally significant settlements in cases in which the dismissal motions had not yet even been heard – the $37.25 million settlement in the American Home case (refer here) and the $30.5 million settlement in the Beazer Homes case (refer here) – suggests that in cases that are sufficiently serious the plaintiffs may be able to avoid the initial pleading hurdle altogether.

The American Home settlement may be particularly noteworthy because in that case both the offering underwriter defendants and the company’s auditor contributed substantially toward the cost of settlement. That, together with the Judge Scheindler’s September 2, 20009 partial denial of the motion to dismiss the claims against the rating agencies in the Cheyne Finance lawsuit (about which refer here), could suggest that in at least some of these cases the possibility of gatekeeper liability could be an important part of the overall claims resolution.

The final point is that these cases are proving to be extremely costly to litigate. The most dramatic illustration of this point is State Street’s August 10, 2009 announcement (here) that the approximately $625 million subprime-related litigation expense reserve the company had established in January 2008 was as of June 30, 2009 already down to $193 million, and further that there could be no assurances that the remaining amount would be adequate for the company’s continuing litigation.

So while the defendants may have won some important victories in the courtroom, the overall costs of defending and settling these cases taken in the aggregate nevertheless continues to look as if it will be enormous. By any measure, the subprime and credit crisis-related litigation wave continues to represent a tremendous loss exposure for D&O insurers.

Will the SEC’s Renewed Aggressiveness Expand Individual Liability Exposures for Corporate Officials?

The SEC is under considerable pressure to reestablish its regulatory credentials and to try to restore its tarnished reputation. As a result, the SEC recently has shown a renewed aggressiveness and even an apparent willingness to try to expand the weapons in its arsenal, in ways that may pose increased threats to corporate officials.

Two recent enforcement actions underscore this pronounced new aggressiveness. First, in July 2009, the SEC launched an enforcement action against the CEO of CSK Auto. As discussed here, the SEC is seeking to clawback the compensation the CEO earned during the period for which the company later restated its financial statements. Significantly, the SEC is pursuing this claim even though the CEO is not alleged to have engaged in any wrongful misconduct or even to have had any role in or knowledge of the issues that triggered the company’s restatement.

The second example of the SEC’s recent aggressiveness is the July 2009 enforcement action filed against two corporate officials at Nature’s Sunshine Products. As discussed here, the SEC sought to impose control person liability on the two officials for the company’s activities that violated the Foreign Corrupt Practices Act, even though the two individuals were not themselves alleged to have been involved in or even aware of the corrupt activities.

Though the SEC’s apparently needs no further encouragement to pursue liability claims against individuals, the agency nevertheless is facing significant additional pressure to target individuals as part of its enforcement activities. Indeed, among other reasons that Judge Jed Rakoff has questioned the proposed settlement of the enforcement action involving the Merrill Lynch bonuses is that the settlement does not involve any specific allegations against or claims against the individuals who caused the alleged wrongdoing to take place. (Refer here for additional details regarding Judge Rakoff’s objections). Regardless of the outcome of the Merrill Lynch settlement, going forward the SEC likely will have to anticipate this objection and incorporate targeted allegations against individuals in an effort to forestall further objections of this kind.

The bottom line is that as a result of these developments, corporate officials could find themselves increasingly on the firing line. Of particular concern is that the CSK Auto and Nature’s Sunshine Products enforcement actions evidence an arguably disturbing willingness on the SEC’s part to try to impose liability on corporate officials even in the absence of culpable involvement in or even awareness of the alleged wrongdoing.

Will Claimants Increasingly Target Outside Directors?

The $61.55 million settlement earlier this year of the claims against the outside director defendants in the Peregrine Systems securities lawsuit is merely the latest example where outside directors have found themselves required to contribute toward a separate settlement of significant liability claims against them. As discussed at greater length here, at least some of the outside director defendants appear to have been required to contribute toward the Peregrine Systems settlement out of their own assets.

As was also shown in the now infamous Just for Feet settlement (about which refer here), the threat that outside directors will be targeted and could be called upon to contribute toward settlement out of their own assets is a growing concern, and one that is significantly increased in the bankruptcy context. Given the growing number of corporate bankruptcies, outside directors could find increasingly find themselves on the front lines of D&O claims.

These developments underscore yet again the need for alternative insurance structures such as Excess Side A insurance to be included as an important part of the corporate D&O insurance program. Indeed, among the defendants whose potential liabilities were settled by the Excess Side A insurers’ contribution in the Broadcom options backdating derivative lawsuit settlement were several of that company’s outside directors.

These cases also highlight the extent to which the outside directors’ liability exposures and interests should be separately considered as part of the construction of a company’s D&O insurance program. Simply put, the outside directors’ interests and the interests of the company’s officers may or may not be completely aligned. These developments and considerations suggest that the non-officer directors could be well advised to have their insurance interests independently reviewed, in order to ensure that their interests are appropriately addressed in the way the company’s insurance program is constructed, as I discuss at greater length here.

What Will be the Next Industry Event for the D&O Insurance Industry?

It is commonly understood that the D&O insurance industry’s historical experience is characterized by a sequence of industry events – for example, we went from the bursting of the Internet bubble to the era of corporate scandals, and we went from options backdating to the subprime litigation wave.

So what will be the next industry event? It might be one or more of the issues discussed above, like the failed bank litigation wave, or the rising number of derivative lawsuits. Or it could be a further extension of existing trends, like the rising numbers of FCPA follow-on civil lawsuits. Or it could be something entirely new, like lawsuits arising from climate change related disclosures.

Only time will tell for sure what the next industry event will be. The one thing that is for certain is that there will another event that will emerge and define the industry’s experience in the months and years that follow.

Is the D&O Insurance Marketplace Headed for a "Hard Market"?

Earlier this year, Advisen took the bold and provocative step of predicting that the D&O insurance marketplace is headed toward a "hard market" as early as late 2009 or early 2010, as discussed at greater length here. Whether or not we are actually headed to an overall harder insurance market remains to be seen, though as 2009 progresses, the possibility to that we will see a hard market earlier rather than later seems less and less likely.

To be sure, the D&O insurance marketplace for companies in the financial sector is definitely harder than for the rest of the marketplace, and some financial institutions are now "hard to place." The speed with which the D&O marketplace for community banks firmed up shows how quickly conditions can change.

Nevertheless, for most companies, particularly those that are financially stable, the D&O marketplace remains competitive, with ample capacity and coverage available on favorable terms and conditions. The pricing declines that have characterized the marketplace over the last several years have largely ended, but outside the financial sector significant pricing increases (at least for financial stable companies) remain the exception.

That is not to say that the possibility of a generalized harder market is completely out of the question. The losses and defense expense associated with the subprime and credit crisis related litigation wave, in combination with several years’ of pricing declines and coverage expansions, could start to affect carriers’ overall results and trigger pricing increases and marketplace restrictions. Whether and when these circumstances might arise remains to be seen.

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In prior posts (refer here), I have observed that the D&O insurer’s consent to settlement really is required. An August 10, 2009 decision by the Delaware Supreme Court (here) confirms that not only is the insurer’s consent required, but the D&O insurer may under certain circumstances reasonably withhold its consent to settlement. The Court, applying Missouri law and observing that the excess carrier in the case had been "cut out" of the settlement process, affirmed the jury’s verdict that the excess carrier had not unreasonably withheld its consent.

Special thanks to Francis Pileggi of the Delaware Corporate and Commercial Litigation Blog (here) for providing me with a link to the opinion. Pileggi's blog post on the opinion can be found here.

Background

Payless Cashways was insured under three different layers of insurance from three different carriers, a primary carrier and two excess carriers. The first level excess insurer is referred to in this post as the excess insurer.

In 2003, Hilco Capital and another entity sued Payless’s directors and officers alleging that in connection with certain loans Hilco made to Payless the defendants had misrepresented the value of Payless’s inventory.

Prior to trial, the parties scheduled a mediation session. The primary carrier’s representative attended the mediation, but because the defense counsel (Shay) and the primary carrier valued the case within the primary insurer’s $10 million limit, and because Shay told the excess carrier’s representative that he would rather try the case than settle for more than the the primary limit, all parties agreed that the excess carrier’s representative should not attend the mediation, but rather  be available by telephone.

After the mediation’s first day, the mediator proposed mediation of a single issue – whether the defendants were aware that a Payless employee had falsified the company’s inventory numbers. He further proposed a "high-low" outcome, whereby the primary insurer would pay Hilco $5 million immediately, and then if Hilco lost the single issue mediation, it would keep the $5 million, but if it won the mediation, it was also get the remaining limits of the primary policy (about $3.7 million) -- and in addition approximately $7 million under the excess insurer’s policy.

Unfortunately, it was 10:00 P.M. by the time the mediation parties agreed to this proposal, and they couldn’t get the excess insurer’s representative on the phone. As the Delaware Supreme Court later put it, "rather than wait until the next morning," the parties finished the deal that night by agreeing that the individual defendants would not be liable for the settlement and would assign their rights under the excess policy to Hilco.

Upon reviewing the memorandum of understanding (MOU), the excess insurer’s representative rejected the proposed settlement, among other grounds on that a "straight" settlement would be lower than the high-end number in the high-low settlement.

The excess carrier asked the mediation parties to withhold finalizing the MOU until after a January 5, 2005 settlement conference, but they did not. The mediation parties later mediated the single issue, and Hilco prevailed. The primary insurer paid its remaining limit. The excess insurer denied coverage for the settlement, asserting a breach of the policy’s consent to settlement requirement.

Coverage litigation ensued. The trial court granted summary judgment for the excess insurer on certain legal issues, and the coverage action then went to trial. The jury found for the excess insurer on three issues: that the individual insureds had breached the policy before the excess insurer withheld consent; that the excess insurer did not unreasonably withhold its consent; and that the excess insurer was not permitted to reasonably associate in the negotiation. Hilco appealed.

The Delware Supreme Court’s Opinion

One of the issues on which the trial court had granted summary judgment was whether or not the excess insurer had breached the covenant of good faith and fair dealing under Missouri law. The Court affirmed the trial court’s ruling but on alternative grounds, holding that even viewing the record in the light most favorable to Hilco, the excess insurer was entitled to judgment as a matter of law.

In reaching this conclusion, the Court noted that "all agreed" that the excess carrier’s representative should not attend the mediation because it would "send the wrong message," so, the Court concluded, there was no breach in the excess carriers’ failure to attend the mediation. And, the Court noted, it was the mediation participants "who refused to wait until the next day to discuss the proposal" but instead "effectively cut [the excess carrier] out of the process by agreeing that the Insureds would assign their rights to Hilco."

Hilco argued that while the MOU was being negotiated, the excess insurer "was willing to negotiate" but that the "straight settlement" it sought required the primary insurer to tender its limits. The Supreme Court noted that the primary insurer refused to tender its limits "because the MOU gave it a better deal," under which, at worst it would pay its limits, but "at best "it would save approximately $3.5 million.

The excess insurer’s "only recourse" under the circumstances was to object to the settlement at the January 5 settlement hearing, but the "mediation participants mooted that effort by executing a definitive settlement agreement the day before the conference." Thus, the Court said based on these circumstances, "in sum, there is no record of a breach of good faith claim against [the excess insurer]."

The Court also ruled in the excess carrier’s favor on other legal grounds and held as well that even if the trial court erred in excluding certain evidence at trial, it "did not deny Hilco a fair trial."

Among Hilco’s evidentiary objections was that the trial court had allowed Shay to testify that the excess carrier "had a reasonable basis to withhold settlement." The Court noted that Shay testified that "he believed it was more likely than not that the Insured would win if the case went to trial and that Hilco had grossly overstated its damages." Shay also testified that he "believed a ‘straight’ settlement could have been negotiated for less than the ‘high’ end …of the high-low agreement."

The Court found that given his testimony "it was obvious" that Shay thought the excess insurer "had a reasonable basis to withhold its consent," so his testimony on that question "did not deny Hilco a fair trial."

The Court reached similar conclusions regarding Hilco’s other evidentiary objections and concluded that because the jury found the excess carrier had "a reasonable basis to withhold its consent," it did not need to reach the jury’s other rulings, and affirmed the jury’s verdict.

Discussion

There are two sides to every story, and there may well be a side to this story that does not appear from the face of the Court’s opinion. Perhaps the information in the excluded evidence paints a different picture.

All of that said, though, the only surprising thing to me about this case is that it went all the way to the Delaware Supreme Court. Pretty clearly, the settlement looked like a set up deal to the jury, and that seems to be the way the Supreme Court saw it too.

Whatever else might be said in defense of the settlement process, it is undeniable that the mediation participants’ actions managed to eliminate any possibility that the process would later appear to have been fair to the excess insurer. Their repeated actions to, as the Supreme Court put it, to "cut out" the excess insurer, make it appear as if their goal was to keep the excess insurer from upsetting a settlement that they clearly found advantageous for themselves, even if objectionable – for obvious reasons – to the excess insurer.

The details of the settlement that the Supreme Court chose to emphasize in its opinion are telling. The Supreme Court twice noted that at the mediation (a mediation "all agreed" the excess carrier’s representative should not attend to avoid "sending the wrong message"), the mediation participants decided not to wait until the following morning to discuss the proposed settlement. Instead, the Court observed, they cut the excess insurer out of the deal, with the assignment of rights and the agreement that the inidividuals would not be liable.

The Court also noted that the mediation participants, having refused even to wait until the next morning to discuss the deal with the excess insurer,  refused to forebear from finalizing the settlement until after the January 5 hearing, depriving the excess insurer of its only means of objecting to the settlement.

In addition to the obvious question of fairness of a process that appears to have been calculated to cut out the excess insurer but that nonetheless exposed its interests, there are the further questions of the fairness of the amount of the settlement and the burden it imposed on the excess insurer, given Shay’s trial testimony about the trial prospects of the underlying case and the appropriate settlement valuations at the high end.

The interesting thing about the outcome of this case is its suggestion that absent a reasonable opportunity to consider a settlement, a D&O insurer may reasonably withhold its settlement consent. The further implication is that a set up deal that deprives a D&O insurer of a reasonable opportunity to consider a proposed settlement may represent a sufficient basis for the insurer to withhold its consent. Perhaps with an awareness of this possibility, other settlement participants might think twice about taking steps that later could be portrayed as cutting an insurer out of the process.

About Those Late Night Settlement Demands: 10 P.M. seems to be a popular time to send D&O insurers unexpected settlement demands. As I noted in a prior post (here), former Globalstar CEO Bernard Schwarz sought his company’s D&O carriers’ consent to a $20 million at 10 P.M. on a Sunday night before his Monday morning trial testimony.

In that case, by contrast to the one discussed above, the Second Circuit held that the insurers’ did not reasonably withhold consent to Schwarz’s settlement. However, the critical difference between that case and the case discussed above is that in connection with his settlement, Schwarz accepted personal liability and in fact funded the settlement out of his own assets while seeking coverage from the carriers. This willingness to assume responsibility for the settlement deprived the carriers of the ability to argue that the amount of the settlement was unreasonable and by extension that their action in withholding consent reasonable.

In other words, the difference between the two cases is that in the case discussed above the deal looked like a set up. That seems to be how the jury saw it and how the Delaware Supreme Court saw it. That is why I say I am surprised the case went all the way to the Supreme Court. It is hard to argue that someone else wasn’t reasonable when your own conduct can be portrayed as unreasonable.

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In a move that recapitulates a classic dispute that has been brewing in bankruptcy court for years, the Stanford Financial Group receiver has asserted that the proceeds of Stanford’s D&O insurance policies are "receivership assets" and that his right to the proceeds "supersedes" the rights of insureds under the policy. Moreover, he has specifically threatened the insurer with "contempt" if it were to advance the individual insureds’ defense expenses. This sequence raises some fundamental issues about the D&O insurance structure and coverage and could highlight the importance of certain policy provisions that have recently become prevalent. It also raises some questions about some coverage structures.

Let me just say at the outset that I am not involved in this case and I do not intend in this post to express my opinions on the merits of the parties’ respective positions. Rather, the purpose of this post is simply to note the parties’ dispute and to make some observations.

According to a June 30, 2009 motion filed in the Stanford Financial SEC proceeding pending by former Stanford CEO Laura Pendergest-Holt (here), Stanford’s D&O insurance carrier had advised her that it would begin advancing her defense expense, subject to a reservation of its rights to deny coverage under the policy, on July 1, 2009. However, on June 25, 2009, the receiver sent the carrier a letter claiming that the D&O policy proceeds are "Receivership Assets" and that the receiver’s right to the proceeds "supersedes" the right of the other insureds under the policy. The carrier has withheld payment.

Pendergest-Holt’s motion seeks clarification that the receivership order does not apply to the D&O policy proceeds, and alternatively seeks authorization for disbursement of the D&O policy proceeds for payment of her defense expense. A host of other individuals claiming also to be insureds under Stanford’s D&O policy have sought to join in Pendergest-Holt’s motion, as reflected, for example, in the August 6, 2009 motion (here) filed by two former Stanford brokers. UPDATE: The receiver's response to Pendergest-Holt's motion can be found here. Special thanks to a loyal reader for providing a copy of the response.

The question of ownership and entitlement to D&O policy insurance proceeds is a long-standing question in the bankruptcy context. This recurring question became even more troublesome after so-called "entity coverage" was added to most D&O policies in the mid-90s. This coverage extension provides liability protection for the company itself. In public company policy’s, the coverage is limited just to securities claims. However, for private companies, like Stanford, the entity coverage is usually more extensive.

As reflected in a memo (here) by my friend Kim Melvin of the Wiley Rein firm, courts have continued to struggle with these issues in bankruptcy, with some courts finding that the policy proceeds are not a part of the bankruptcy estate and therefore not subject to the stay in bankruptcy, and others reaching a contrary conclusion.

But these questions may take on a different light in the context of the question of the advancement of defense expenses subject to a carrier’s reservation of rights. In these circumstances, policy funds are advanced without a final determination of coverage (one that might, in fact, never come, if the claims are compromised). When it comes to the entitlement to advancement of defense expense, it could be argued that, all else equal, the various insureds’ rights -- including the bankrupt company’s rights – under the policy could be regarded equivalent.

These issues could be even further complicated where, as here, the bankrupt company faces a likelihood of its own third-party liability claims, in which the company will likely incur its own defense expense.

One critical element of this dispute may be the question whether Stanford’s policy has a priority of payments provision, which predetermines the order of payment under the policy. This type of provision has become fairly standard in recent years. These provisions generally specify that payment of loss will first be made under the policy’s A Side coverage (which provides individual protection in the event the corporate entity is unable to indemnify them due to insolvency or legal prohibition). These provisions confirm the parties’ intent that the D&O policy serves primarily to protect the individual directors and officers.

Whether Stanford’s policy has this type of provision, and if so how the court will interpret and apply it here remains to be seen. The court’s interpretation of this provision (assuming it is in the policy) could be determinative of the parties’ dispute.

While the outcome of this dispute remains to be seen, the receiver’s position caused me to reflect on an auxiliary D&O insurance policy that many insureds have acquired in recent years, the so-called Excess Side A/DIC policy. The "difference in condition" coverage extension under this type of policy provides that the policy will "drop down" and provide first dollar coverage under certain circumstances.

Although these policies vary significantly, one of the relatively standard features of the DIC coverage is a provision specifying that the policy will "drop down" and provide first dollar coverage if the insured company is in bankruptcy and the proceeds of any traditional underlying insurance cannot be paid because the proceeds are subject to the automatic stay.

The circumstances of the dispute involving the Stanford D&O insurance policy present a situation where the individual insureds might well find themselves unable to access the protection of a traditional D&O insurance policy, at least if the receiver’s current efforts are successful. However, even if Stanford Financial D&O insurance program included a Side A/DIC policy, the typical Side A/DIC policy would not appear to provide drop down protection to the individual insureds in this circumstance, because their inability to access the policy proceeds is not as the result of the initiation of an action under the U.S Bankruptcy Code and not as a result of the automatic stay in bankruptcy.

The apparent nonapplicability of the drop down coverage to these circumstances under the typical Excess Side A/DIC policy made me reflect that there could be a need for an extension of the DIC coverage’s drop down protection to circumstances like this one where the proceeds of the traditional D&O insurance policy may be unavailable for the individual insureds’ protection for reasons other than the operation of the U.S. Bankruptcy Code. There may well be some DIC policies out there that might respond in this situation, but the typical Excess Side A/DIC policy likely would not.

The Stanford Financial insurance dispute will be interesting to watch, although it is an extremely unwelcome situation from the perspective of the individuals involved. In any event, the specifics of the situation suggest a possible (and arguably necessary) extension of the DIC coverage in the typical Excess Side A/DIC policy.

I know that many readers may have much more experience with the coverage issues involved in the receiver’s actions in the Stanford Financial case, and many readers may also have views about the extent and limitations of the typical Excess Side A/DIC policy. I encourage readers to share their views with others using the blog’s "Comment" feature.

Quelle Surprise: The Lawyers Want to Be Sure They Will Be Paid: Among other things, the receiver’s asset freeze together with the dispute of over the D&O policy proceeds may have left the various individuals’ lawyers wondering when and how they will be paid. R. Allen Stanford’s new criminal defense lawyers want assurance they will be paid before they will take any actions.

As reflected in an August 10, 2009 Texas Lawyer article entitled "Stanford’s Lawyers Want Assurance on Pay" (here), Stanford’s erstwhile new legal defense team has entered an appearance in the criminal proceeding against Stanford – solely for the limited purpose of determining "whether Mr. Stanford will be granted access to monies to pay for his legal fees and expenses."

"Private Companies Need D&O Insurance, Too": The Stanford Group case may represent an extreme example, but it does illustrate that private companies can become involved in serious claims for which D&O insurance is required. But many private company officials remain unconvinced of the need for D&O insurance, particularly when it comes to closely held companies.

A recent memo by Shannon Graving and Thomas H. Bentz, Jr. of the Holland & Knight law firm entitled "Private Companies Need D&O Insurance, Too" (here) takes a look at this recurring question about private companies and D&O insurance. As the article shows, private companies and their directors and officers may be susceptible to a wide variety of claims, as a result of which, the companies – even family owned businesses – would be well advised to secure D&O insurance protection.

More Madoff-Related Coverage Litigation: As I noted in a prior post (here), Madoff-related coverage litigation has started to arrive, and there undoubtedly will be more to come. Along those lines, Bloomberg reported today (here) that Madoff feeder fund Tremont Group Holdings and its related organizations have filed an action in Delaware Chancery Court against its insurers for denying coverage for Madoff-related claims.

According to the article, Tremont is owned by OppenheimerFunds, a unit of Mass Mutual Financial Group. The article reports that the complaint alleges that Mass Mutual’s D&O insurers and its bond insurers "have ignored repeated requests to pay defense costs." The complaint apparently contends that MassMutual’s D&O insurer has taken the position that the company’s bond insurer should pay a portion of the defense expense, but that "the primary bond underwriters have refused to pay any portion of the joint defense expense." The complaint seeks a judicial declaration of coverage under the applicable policies.

I don’t yet have a copy of this complaint, but I will post a link as soon as I get a copy. I would be grateful if any reader that has a copy of the complaint would forward a copy to me (anonymously, of course, if necessary), so that I can post the link. UPDATE: A copy of the complaint can be found here. Special thanks to a loyal reader for providing a copy of this complaint.

Special thanks to a loyal reader for sending me a copy of the Bloomberg article.

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Claims arising out of corporate bankruptcy represent a significant stress test for directors’ and officers’ liability insurance coverage. Among other frequently recurring issues are questions whether post-bankruptcy claims against the bankrupt company’s directors and officers run afoul of the Insured vs. Insured (I v. I) exclusion found in most D&O insurance policies.

In a July 10, 2009 opinion (here) that highlights many of these perennial bankruptcy-related D&O insurance coverage issues, the Ninth Circuit held that a D&O policy’s Insured vs. Insured exclusion bars coverage for claims that were brought against former directors and officers of a bankrupt company by the post-bankruptcy debtor in possession and later assigned to a creditors’ trust. The decision may have important implications for the prospective wording of coverage “carve backs” from the  I v. I exclusion.

Background

Visitalk, which had filed a Chapter 11 bankruptcy petition, and while acting as “debtor and debtor in possession,” sued four of its recently discharged directors and officers for breaches of their fiduciary duties. Visitalk’s D&O insurers refused coverage for the claim, in reliance on the I v. I exclusion.

Visitalk’s primary D&O insurance policy’s I v. I exclusion provided as follows:

V. EXCLUSIONS

The Insurer shall not be liable to make any payment for Loss in connection with any Claim made against the Directors and Officers . . .:

(D) brought or maintained by or on behalf of an Insured in any capacity or by any

security holder of the company except:

(1) a Claim, including, but not limited to, a security holder class or derivative action that is instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of an Insured;

(2) an Employment Practice Claim3 by a former Director or a present or former Officer;

(3) a claim for contribution or indemnity if the Claim directly results from another Claim that is otherwise covered under this Policy; or

(4) a claim by any employee(s) of the Company described in IV.(D)(2) of the Policy.

Visitalk filed a Chapter 11 reorganization plan that assigned its claims against the directors and officers to a trust created by the creditors. The trustee for the creditors trust (Biltmore) and the four director and officer defendants agreed to settle Visitalk’s claims for about $175 million. The four directors and officers assigned to the creditors’ trust their rights against the D&O insurers. (The record does not disclose whether or not the settlement with Biltmore also included a provision typical of these kinds of arrangements, which is a covenant by the settling claimant not to execute any judgment entered pursuant to the settlement on the assets of the settling defendants.)

Biltmore, as trustee for the creditors’ trust, then sued the D&O insurers in reliance on the individuals’ assignment to Biltmore of their rights under the D&O policies. The District Court dismissed Biltmore’s complaint on narrow grounds relating to the relation between Visitalk’s primary D&O insurer and the primary insurer’s successor in interest. The Ninth Circuit did not reach the successor in interest issue but nevertheless affirmed the District Court’s dismissal of the case on the grounds that the I v. I exclusion applies.

The Ninth Circuit’s Opinion

The Ninth Circuit’s July 10, 2009 opinion (here) written by Judge Andrew J. Kleinfeld opens with a review of the reasons for the inclusion of an insured vs. insured exclusion in D&O insurance policies, noting that “because risks such as collusion and moral hazard are much greater for claims by one insured against another insured … than for claims by strangers, liability policies typically exclude them from coverage.”

The Court then noted that because none of the exceptions to the policy’s I v. I exclusion apply, the only question was whether the underlying suit was “brought or maintained on behalf of an Insured in any capacity.”

The Court found that the underlying claim had been “instigated and continued” by Visitalk as Chapter 11 “debtor and debtor in possession.” Though coverage was now being sought by the trustee of the creditor’s trust, it was doing so merely as an assignee. The court noted that “an assignee of a claim against an insurance company can have no stronger claim than the assignor who assigned the claim.”

The question then is whether Visitalk’s status as debtor in possession at the time it initiated the claim triggered the I v I exclusion.

Biltmore argued that Visitalk, the chapter 11 debtor in possession that brought the underlying suit, is not the same entity as Visitalk, the insured corporation. However, the Ninth Circuit concluded after a review of authorities that “for purposes of the insured versus insured exclusion, the prefiling company and the company as debtor in possession in chapter 11 are the same entity.”

The Ninth Circuit acknowledged that “it is certainly true that interests differ once a debtor goes into bankruptcy.” Among other things, due to the bankruptcy “ownership of the cause of action fell into the bankruptcy estate” and Visitalk as debtor in possession of the bankrupt estate was “empowered to act as fiduciary for its creditors and shareholders.”

Biltmore argued that because Visitalk as debtor in possession was acting as representative for the estate’s creditors in bringing the suit, the I v. I exclusion does not apply. The Ninth Circuit reasoned that while suit might be brought for the benefit of creditors, it was not brought “on behalf of” the creditors. The Ninth Circuit said that the suit is “for the benefit of the creditors, but on behalf of the pre-bankruptcy corporation.”

The Court said that the question was not whether the creditors might benefit from any recovery. The court said that the insurance “cannot be turned into an available pot for the corporation’s creditors by enforcing the insurance obligations while disregarding the parties’ agreement to limit those obligations to exclude insured versus insured claims.”

The Ninth Circuit concluded its analysis of the I v. I exclusion issues by noting that a contrary holding would

create a perverse incentive for the principals of a failing business to bet the dwindling treasury on a lawsuit against themselves and a coverage action against their insurers, bailing the company out with the money from the D & O policy if they win and giving themselves covenants not to execute if they lose. That is among the kinds of moral hazard that the insured versus insured exclusion is intended to avoid.

Discussion

As I have previously noted (here), the insured vs. insured exclusion is heavily litigated and continues to be at the heart of many D&O coverage disputes, particularly in the bankruptcy context, as this case demonstrates. In response to these many continuing disputes, the exclusion itself has continued to evolve, and the I v. I exclusion in the typical D&O policy in today’s marketplace is quite a bit different than the exclusion at issue in the Visitalk case.

Among other things, the I v. I exclusion in most D&O policies today contain additional exceptions to the exclusion, or coverage “carve banks” as they are usually called. Among other provisions now more or less standard is a carve back to the I v. I exclusion specifically relating to the bankruptcy context. A typical carve back of this type would specify that the I v. I exclusion would not apply “in any bankruptcy proceeding by or against an Organization” to “any claim brought by an examiner, trustee, receiver, liquidator or rehabilitator (or any assignee thereof) of such Organization.”

It would have been interesting to see how the Ninth Circuit would have addressed the issues in the Visitalk case if the policy as issue had contained these now fairly standard provisions. However, even if Visitalk’s policy had contained a carve back of this kind, it likely would not have altered the outcome, because the underlying action in the Visitalk claim had not been brought by any of the creditors’ representatives referenced in the carve back, but rather had been brought by Visitalk as debtor in possession.

The solution to this coverage problem would seem to be simply to include the debtor-in-possession in the list of bankruptcy-related claimants for whose claims coverage is carved back as an exception to the exclusion. Indeed, parts of the Ninth Circuit’s opinion in the Visitalk case suggest that this would be appropriate, particularly the Court’s comments about how a debtor’s status changes upon becoming a debtor in possession, and how an action by a debtor in possession as representative of the estate is for the benefit of creditors.

However, throughout the Ninth Circuit’s opinion is a pervasive concern with the possibility of collusive litigation. The Court clearly was concerned that if there were coverage, a debtor in possession action might represent a collusive attempt by a debtor company to use the cover of a bankruptcy filing and the ruse of a supposed claim as a way to access insurance proceeds to pay off the company’s debts.

Without minimizing the collusive possibilities to which the Ninth Circuit refers, I believe there is also a legitimate concern that without policy recognition in some way for debtor in possession claims, individuals could be left without insurance for claims of a kind for which D&O policies are intended to provide coverage.A debtor in possession claim is not inevitably collusive, and in that regard I note that the individuals named as defendants in the underlying suit in the Visitalk claim were former directors and officers, targeted post-bankruptcy on behalf of the bankrupt estate.

There are, in fact, D&O insurance policies available in the current marketplace that attempt to address the problem of debtor in possession claims. For example, one policy’s list of the bankruptcy-related claimants for whose claims coverage is carved back include “a Claim by the Entity as Debtor-in-Possession after such Examiner, Trustee, Receiver has been appointed.” The prerequisite for the availability of coverage under this carve back for the appointment of an examiner or trustee does represent some check against the collusive possibilities about which the Ninth Circuit was concerned.

Whether or not this particular formulation is sufficient to preclude the possibility of collusive claims, it strikes me as a step in the right direction toward protecting against the possibility that individuals could otherwise be left without coverage for claims of a kind for which these policies were intended to provide protection.

To be sure, the individual defendants in the Visitalk claim were not left to defend themselves without coverage; they entered into the settlement and assignment of rights with the trustee to the creditors’ trust. The parties’ entry into this settlement arrangement clearly troubled the Ninth Circuit, and the Court’s concerns about these kinds of settlement and assignment of rights deals clearly affected the court’s analysis. However, it should be noted that there is nothing about the debtor in possession claim context that uniquely encourages this kind of settlement, and litigants in many other contexts enter similar arrangements. Indeed, if the individuals were clearly covered and thus able to defend themselves, they would have far less incentive to enter these kinds of arrangements.

While I don’t mean to trivialize concerns about the possibility of collusive claims, for me the most important message from the Ninth Circuit’s decision in the Visitalk case is not necessarily the threat of collusive claims but rather then need to address in the policy the possibility of debtor in possession claims against individual directors and officers. The clear implication seems to be that the now fairly typical bankruptcy-related coverage carve back to the I v I exclusion should be modified to preserve coverage for debtor in possession claims.

One final observation about this particular coverage problem is that whether or not the primary D&O insurer will agree to provide a coverage carve back in the I v I exclusion for debtor in possession claims, an insured company may be able to purchase an excess Side A policy providing “difference in condition” protection and that either does not contain an I v. I exclusion or has one that is very narrowly circumscribed.

Because of the issues raised in the Ninth Circuit’s opinion, particularly the court’s concerns about the possibility of collusive claims, I would like to hear readers’ views about these issues, and I encourage everyone to post their thoughts for others using this blog’s “Comment” feature.

Very special thanks to Mike Early of the Chicago Underwriting Group for providing me with a copy of the Visitalk opinion. I hasten to add that the views expressed in the blog post are exclusively my own.

2009 Failed Banks – The Slideshow: This past Friday night, the Bank of Wyoming of Thermopolis, Wyoming, became the fifty-third bank to fail this year (refer here for more details). Regular readers know that the FDIC maintains a detailed list of failed banks (here). But who needs a list when you can see a slideshow, including pictures of all of the banks that failed this year? Check out Clusterstock’s failed bank slideshow, which is complete prior to the closure of the Bank of Wyoming, and can be accessed here.

Mid-Year Review: Securities Litigation and Enforcement: On July 9, 2009, I participated in a Securities Docket webinar entitled “Mid-Year Review: Securities Litigation and Enforcement” that included as panelists Lyle Roberts of the 10b5-Daily blog, Francine McKenna of the Re: The Auditors blog, Tom Gorman of the SEC Actions blog, as well as Bruce Carton of Securities Docket. Carton has posted a brief summary of the topics discussed in the webinar in a July 10, 2009 Compliance Week column entitled “Bloggers Offer 2009 Mid-Year Review” (here).

The webinar itself is available to be viewed online and can be accessed below:

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Most reasonably sophisticated consumers understand that the cheapest running shoes may be no bargain, that the least expensive cellular plan may have big gaps, and that selecting legal counsel based on which attorney charges the least is fraught with peril. Yet when it comes to D&O insurance, these same buyers are often only concerned with which is the lowest cost alternative, without complete consideration whether the cheapest coverage fully addresses their insurance needs.

The assumption behind many insurance purchasing decisions is that the various alternatives are basically equivalent, and the only relevant variable is price. Whether or not this assumption would be valid for personal insurance like home or auto, for which the insurance is generally issued on standard forms, it definitely is not true with respect to D&O insurance.

There is no standard D&O insurance policy form; to the contrary, the various carriers’ base forms vary significantly, and many of the key terms are negotiable, particularly with respect to public company D&O insurance.

So the assessment of D&O insurance alternatives often involves – or rather should involve – careful comparison between a host of relative advantages and disadvantages, among which price is one of many important factors to be considered.

Despite the many subtle but nonetheless critically important differences between D&O insurance alternatives, many insurance buyers, even those who otherwise qualify as very sophisticated, ultimately make their selection based solely upon price, even though they would never depend solely on price alone when selecting, say, a pair of running shoes, a cellular plan, or an attorney to represent them.

When it comes to running shoes, cellular plans or attorneys, consumers both understand what these goods and services are for and they also fully expect to use these goods and services. When it comes to D&O insurance, however, the same buyers are unconsciously assuming that they will never actually need to use the product, and that the insurance acquisition is nothing more than a box-checking exercise. D&O insurance? Yep, got that.

The one subset of insurance buyers who do not need to be reminded when selecting among D&O insurance alternatives of how important it is to consider all issues, and not just price, are company officials who have previously been involved in a D&O claim. These individuals fully understand what D& O insurance is for, and they often have a deep appreciation of the way that seemingly small difference in policy language can have a significant impact on the extent of coverage in the event of a claim.

After over a quarter of a century of involvement with directors’ and officers’ liability issues, I have seen hundreds of claims involving thousands of individual director and officer defendants. I have seen highly regarded individuals, who have amassed a lifetime’s worth of wealth and prestige, have everything they worked for their entire careers come crashing down around them. I have seen formerly powerful executives taken away in handcuffs. I have seen grown men cry. None of these individuals ever thought they would ever find themselves in these circumstances – but they did. I guarantee you that not one of them, finding themselves caught up in these circumstances, thought to themselves “Boy, I sure am glad we got the cheapest D&O insurance we could find.” .

The D&O insurance acquisition process cannot be built on the assumption that those things might happen, but not to my company and certainly not to me.  The entire acquisition process has to be built on the assumption that these things will happen to this company.

Of course, not all D&O claims are catastrophic, but the one thing I know for sure about D&O claims is that, whether or not they are catastrophic, the quality of the D&O insurance available at the time of the claim is critically important. The time to analyze whether or not the D&O insurance program is built to respond to the range of possible claims circumstances is not when the claim comes in, but when the insurance is purchased.

Cost is of course an indispensible consideration and price considerations should always be taken into account. In fact, I have many times recommended to clients that they select an alternative that is the lowest cost option. But when I make that recommendation, price alone is neither the sole nor the most important criterion.

D&O insurance buyers whose advisors recommend the lowest priced alternative need to consider whether (a) the advisor is recommending the lowest priced alternative because it really is the best option for the company based on full consideration of all relevant factors; (b) the advisor is recommending the lowest price alternative because he or she thinks that is what the buyer wants to hear and that’s what it will take for the advisor to get or keep the business, and he or she doesn’t have the guts to provide an independent and fully considered recommendation; or (c) the advisor doesn’t have a clue what the important differences are between the available alternatives and the only distinction the advisor can explain is the cost difference.

I am often asked to review public companies’ D&O insurance programs. In many cases, the companies have insurance programs that are more or less matched to their requirements and circumstances. But in a surprising number of cases, the programs I review lack critically important features that could dramatically affect the availability of coverage in various claims circumstances. Sometimes these underserved policyholders are also over-paying for their insurance, which has its own set of implications. But more often, the company itself has selected into an inadequate insurance program because they chose their insurance based solely on price.

Price considerations alone are not enough to allow a buyer to select the best running shoes, cellular plan or legal counsel. Price considerations are important of course, because no one should overpay for something. Often the way to make the optimal purchase is to get assistance from someone who knows more about the products and services.

Insurance buyers may never have to use their D&O insurance, but policyholders don’t want to find out when a claim arises that the cheap insurance they bought was no bargain. That is why it is indispensible to have a skilled and experienced insurance advisor involved in the D&O insurance transaction, one that understands and can explain the differences between the insurance alternatives and that can recommend the alterative that will best meets the company’s needs and finances.

Where are You Going, Al? Can’t You Read?: Any alpaca having the temerity to disregard this sign will find itself in very serious trouble.

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In what has become a weekly ritual as 2009 has progressed, each Friday evening after the close of business, the Federal Deposit Insurance Corporation (FDIC) announces the names of the banks it has taken over that week. The current number of year-to-date bank closures stands at 37, which already represents the highest annual total since 1993, the end of the last era of failed banks. All signs are that the number of bank failures will continue to grow in the months ahead, a prospect that is affecting the D&O insurance marketplace, even for smaller community banks.

In the latest issue of InSights (here), I take a look at the background regarding the current wave of bank closures and examine the D&O insurance marketplace’s reaction to these developments.

One of the issues discussed in the article is the surprising number of failed banks in Georgia. The June 10, 2009 Wall Street Journal has an article entitled "Failed Banks's Dot Georgia's Vista" (here) discussing the reasons for the high number of bank failures in that state.

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One byproducts of the turmoil that has swept over insurance giant AIG has been a cascade of litigation. But even before the company’s latest woes, it was locked in a series of hotly contested legal battles with its former Chairman and CEO, Maurice Greenberg. The latest front in this ongoing war apparently is a fight over the proceeds of the company’s primary D&O insurance policy, as a result of which the D&O insurer has now initiated an interpleader action to sort out whose claims to the policy proceeds should prevail.

As reflected in the complaint (here) that the insurer filed on May 8, 2009 in the Southern District of New York, the insurer issued a $15 million primary D&O insurance policy over a $10 million self-insured retention for the policy period May 24, 2004 through May 25, 2005. As the D&O insurer’s complaint notes, "AIG is at the center of a firestorm," as a result of which the company and its present and former directors and officers are the targets of numerous lawsuits. (The lawsuits themselves are not specified in the D&O insurer’s complaint.)

But as the insurer’s complaint observes, "even before the current issues at AIG became front page news, a very public split" occurred between AIG and Greenberg, as a result of which the company and Greenberg have "taken strongly adversarial positions" in the various lawsuits that have accumulated against AIG. Both AIG and Greenberg and his related entities have expended significant sums in their defense of the underlying litigation, and both AIG, on the one hand, and Greenberg and his related entities, on the other hand, have demanded that the D&O insurer advance to them the proceeds of the D&O policy, presenting the insurer with "competing adverse demands to the proceeds of the Policy."

According to the complaint, AIG was advancing Greenberg’s defense expenses until mid-2007, after which Greenberg’s defense expenses were advance by his various related entities. The D&O insurer’s complaint alleges that the defense expenses that AIG has incurred on Greenberg’s behalf and on behalf of other individual defendants in the underlying litigation exceed both the D&O policy’s $10 million self-insured retention and its $15 million limit of liability.

The D&O insurer’s complaint is filed in the form of an interpleader action under Rule 22 of the Federal Rules of Civil Procedure. Using this procedure, the insurer is basically disclaiming any right or interest in the policy proceeds, and tendering them to the court, for the court to sort out the competing interests to the policy proceeds.

The precipitating event that triggered the initiation of the interpleader action was the attempt by Greenberg to pursue arbitration, in reliance on the arbitration clause in the D&O insurance policy. While the policy does provide for arbitration, Greenberg did not join AIG as a party to the arbitration, while at the same time purporting on his own to select an arbitrator. The D&O insurer is concerned both that AIG must be a party to the arbitration, and that the Policy reserves to AIG rather than to individual insureds the right to select the arbitrator.

In light of this separate arbitration proceeding, the D&O insurer’s recently filed complaint seeks, in addition to interpleader, a judicial declaration whether or not Greenberg is entitled to use the arbitration procedure under the policy, and if so whether AIG is a necessary party to the arbitration, as well as whether or not AIG has the right under the policy to select the arbitrator. The D&O insurer also seeks a judicial declaration of the appropriate disposition of the policy proceeds pending the outcome of the arbitration.

Obviously one of the things that makes this new action interesting is the high profile of the litigants involved. But the case is also interesting as an illustration of the kinds of problems that can arise between current and former directors and officers – clearly, the disputes can even include vehement disagreement over the proper allocation and distribution of D&O insurance proceeds.

The arbitration dispute also demonstrates some the shortcomings that can arise in the application of arbitration provisions in a D&O insurance policy. The sequence of events here not only raises questions about who can initiate arbitration, but also who has what rights in the event of an arbitration. Individual insureds might well be concerned to learn that their company could reserve the exclusive right to select arbitrators in any dispute in which the individuals might become involved with the D&O insurer. (These issues illustrate one reason why I have always thought that the preferred approach to alternative dispute resolution clauses in an insurance policy is for the specified procedures to be at the option of the aggrieved insured, rather than mandatory.)

Another interesting note in this dispute is that it relates to a D&O insurance policy that incepted in 2004. Obviously, the hottest parts of the "firestorm" in which AIG is now engulfed arose well after the policy period for the policy that is in dispute in this case, raising the question of how many (if any) other policy years’ of coverage have been triggered by the various lawsuits in which AIG is involved. How many of the various lawsuits "relate back" to this policy year, and how many triggered policies that were in force in subsequent policy periods? The total amount of insurance potentially in play depends on the outcome of this question.

It is also worth noting that the interpleader complaint described above involves only the primary policy in AIG’s D&O insurance program for the policy period 2004-05. AIG undoubtedly carried significant additional amounts of insurance (i.e., excess insurance) during that same policy period. While the excess insurers in the program may be indifferent whether the primary policy is exhausted in payment of AIG’s or Greenberg’s defense expenses, once the primary policy is exhausted, the dispute between AIG and Greenberg will just move up to the first level excess carrier, and so on up the ladder.

So it is obviously important to the excess insurers to know how the present dispute is resolved, because the outcome potentially could dictate the excess carriers’ rights, obligations and interests.

One final point that the many claimants in the various lawsuits pending against AIG and its present and former directors and officers may well want to note is that the deluge of litigation in which AIG is involved is rapidly depleting whatever amounts of insurance may remain. At some point, the insurance could well be exhausted even just by defense expense alone, leaving only the assets of the now nationalized entity as the primary source of funds out of which to try to extract a settlement or judgment – putting the claimants’ interests in direct conflict with those of U.S. taxpayers.

The theoretical possibility that these claimants might be able to recover from the individual defendants out of the individuals’ own assets must be tempered by the awareness that these individuals, although once wealthy, had most of their net worth tied up in AIG stock. My point here is that well-advised claimants might want to focus on trying to figure out how to maneuver cases toward settlement as soon as possible with the least possible additional defense expense. Not that I have a dog in this particular fight, I’m just saying …

Bloomberg reporter Thom Weidlich has a May 11, 2009 article about the interpleader action, here.

Mayday, Mayday!: Readers may be interested to know that Hank Greenberg just celebrated his 85th birthday on May 4. Everyone here at The D&O Diary wishes Hank a belated Happy Birthday.

And speaking of May anniversaries, with a May 24 inception and expiration date for the insurance policy at issue in this dispute, is it possible that the AIG D&O insurance program is up for renewal once again in just a few days?

Pertinent to the possibility of an impending AIG D&O insurance renewal during the month of May, I note that, according to Wikipedia (here), the universal distress signal "mayday" is a derivation of the French expression "m’aider," short for "venez m’aider," meaning "(you) come help me."

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Deteriorating economic conditions threaten a massive wave of corporate defaults.  Corporate borrowers’ inability to fulfill debt obligations could not only prompt a bankruptcy filing surge, but could also result in a flood of lawsuits and claims as creditors and shareholders seek to recoup their losses.  These claims could present a host of challenging D&O coverage issues. 

In the latest issue of InSights (here), I take a look at the conditions that could contribute to an increase in corporate bankruptcies, the likelihood that more bankruptcies could translate to increased litigation, and the D&O insurance issues that bankruptcy litigation could present.

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The global financial crisis has produced challenges across the entire economy, but the financial sector, where all the problems arguably began, has been particularly hard hit. While the most investment firms and other banking institutions may have experienced the most dramatic consequences, insurance companies have also been swept up in the whirlwind.

The extent of the recession’s impact on insurance companies and the resulting consequences for the insurance marketplace are the subjects of an April 2009 paper from insurance industry data firm Advisen entitled "The Impact of the Economic Crisis on the P&C Insurance Industry" (here, $ required). Advisen’s April 2, 2009 press release describing the report can be found here.

According to the paper, the various economic forces at play will likely shrink insurers’ policyholder surplus, thus diminishing the supply of insurance. These circumstances ordinarily would produce a so-called "hard" market, characterized by rising prices for insurance. However, the reduction in economic activity as a result of the current recession could also reduce the demand for insurance, which in turn could complicate the insurance cycle’s transition and "make for a very turbulent 2009" for the insurance industry.

The major cause for the reduction in the demand for insurance, which according to the paper could delay the transition to a hard market, is "shrinking exposure units." An exposure unit is the basis for calculating premium – for example, the size of an employer’s workforce will determine the employer’s workers comp and EPL insurance premiums.

Many of the exposure units that are critical for determining pricing for a variety of insurance lines – such as sales, real estate square footage, number and mileage of vehicles, payroll, and property values – are all likely to shrink in the months ahead, as a result of the recession. The shrinking exposure base will produce a fall-off in insurers’ top-line revenue.

In addition, insurance demand will also likely be further eroded as businesses close or fail. Even companies that survive may seek to increase self-insured retentions or limits, as a way to cut costs.

The reduction in demand will also likely be accompanied by a reduction in supply, in the form of policyholder surplus, both as a result of increased claims losses and as a result of diminished investment income and investment losses.

The likely increased claims losses could arise from a variety of sources. The paper states that job losses frequently are accompanies by an increase in the frequency and severity of workers’ comp claims. Reductions in force also could trigger EPL claims. And as has been well documented on this blog (refer here), the current economic crisis has also produced a wave of shareholder claims. As the Advisen report notes, these claims are particularly complex which will make them costly to defend and could also make them costly to resolve. D&O claims arising from bankruptcies and E&O claims arising from the various Ponzi scheme scandals could exacerbate the claims losses that insurers experience.

On the investment side, insurers’ investment results have taken a massive hit. Many insurers have had to take huge write-downs, both in their fixed income assets and with respect to more exotic investments. A few insurers have been particularly hard hit with valuation issues concerning "toxic" assets.

In more typical cycle transitions, insurance pricing swings result from changes on the supply side (i.e., policyholder surplus). But the depth of the current economic crisis could also uncharacteristically affect the demand for insurance. One proxy for insurance demand is GDP. When policyholder surplus declines relative to GDP, a hard market usually follows. In the current circumstances, GDP is under pressure, but the decline in policyholder surplus is relatively greater.

These circumstances, together with the likely difficulty insurers will face trying to raise fresh capital, suggest that the insurance marketplace will eventually harden, and higher premiums eventually will result. The Advisen paper projects that the hard market could "begin to set in" as early as mid-2009, and in any event no later than 2010.

However, the hard market will "likely take off slowly" due to lack of consumer and business confidence. When it comes, though, the hard market "could extend longer than previous hard markets owing to the lack of new capital entering the market."

The Advisen report is accompanied by extensive supporting data and analysis, and I think the author makes an excellent point about the pressure that the recession will put on the demand side of the insurance equation

As for the report’s predictions of the arrival and timing of a forthcoming hard market, I guess time will tell. In my view, a hard market is characterized by more than just rising prices; among other things, it also means a shortage of capacity as well as a constriction of terms and conditions. If there really were going to be a hard market as early as mid-2009 (which at this point is only a couple of months away), you would expect some sign of these things in the marketplace, but so far there is very little evidence of any of these things. Which at a minimum suggests to me that if there is going to be a hard market, its arrival could be more delayed than the report suggests.

That said, the report does make a compelling case for the likelihood that there actually will be a hard market this time. It may not be a question of whether, but only of when. Overall, the report is interesting and provides useful analysis of the current insurance marketplace and its likely future direction. The report is well worth reading at length and in full and I commend it to everyone.

Rescission Denied: Policy rescission is a controversial topic. But because the debate often involves high profile cases where the insurer has successfully rescinded a policy, it is sometimes overlooked how difficult it is for insurers to rescind coverage. A recent decision illustrates the difficulties carriers face when they seek to rescind a policy.

In a March 25, 2009 opinion (here), New York (New York Country) Supreme Court Justice Charles Ramos granted summary judgment for JP Morgan Chase in an insurance dispute involving several high profile claims. An excess insurer in J.P. Morgan’s bankers professional liability insurance program had sought to rescind its policy based on alleged misrepresentations in the company’s 2001-02 insurance renewal.

The excess insurer claimed that the company had made misrepresentations about its exposure to Enron, both in a Notice of Potential Claim submitted under the prior insurance program and in a Press Release.

As reflected in the April 2009 memo from the Proskauer Rose law firm entitled "Court Grants Summary Judgment Dismissing Insurer’s Rescission Claim" (here), Judge Ramos found that the Notice and the Press Release were not part of the renewal materials, and the insurer had not asked the company to warrant either document in connection with the renewal.

Judge Ramos also found that there was no issue of triable fact either that the insurer’s underwriters relied on the documents or that the company officials who prepared the documents were aware of any misrepresentations in the documents.

Judge Ramos also found that the insurer had waived rescission because it did not raise the defense until 2006, several years later, and had retained the premium.

While much more might be said about this decision, if nothing else, Judge Ramos’s opinion demonstrates the many hurdles carriers face in attempting to rescind a policy. Any carrier considering policy rescission might well want to review the opinion.

A prior post in which I discuss the difficulties carriers face in attempting to rescind coverage can be found here. Among other things, I note that "policy rescission wreaks havoc on all concerned."

Special thanks to John Gross and Michelle Migdon of the Proskauer Rose firm for providing a copy of the opinion.

More About the Bailout: Much has been written and said about the gargantuan federal bailout. A March 19, 2009 Rolling Stone article entitled "The Big Takeover" (here) presents a particularly irreverent and occasionally profane perspective on the subject.

Although the overall tone of the article borders on feverish, and the article definitely tends toward the conspiracy view of the world, it also contains some funny lines as well as some interesting observations. I particularly liked the author’s take on AIG: "AIG is what happens when short, bald managers of otherwise boring financial bureaucracies start seeing Brad Pitt in the mirror."

The article’s overall take on the bailout is summarized in this paragraph:

In essence, Paulson and his cronies turned the federal government into one gigantic, half-opaque holding company, one whose balance sheet includes the world's most appallingly large and risky hedge fund, a controlling stake in a dying insurance giant, huge investments in a group of teetering megabanks, and shares here and there in various auto-finance companies, student loans, and other failing businesses. Like AIG, this new federal holding company is a firm that has no mechanism for auditing itself and is run by leaders who have very little grasp of the daily operations of its disparate subsidiary operations.

The report concludes with the observation about the bailout that "it’s AIG’s rip-roaringly shitty business model writ almost inconceivably massive." (I should probably emphasize that the view in the article quoted above are those of the article’s author, and do not necessarily represent the view or sentiments of this blog’s author.)

Special thanks to a loyal reader for providing a copy of the Rolling Stone article.

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Among the recurring sources of D&O insurance coverage disputes are issues relating to timely notice of claim. A 6-3 decision by the Texas Supreme Court on March 27, 2009 (here), written over a vigorous dissent (here), recapitulates many of the perennial notice issues and reaches a result that while unquestionably policyholder friendly also poses certain concerns.

Background

At the time of FlashNet Communications May 2000 merger with Prodigy Communications, FlashNet purchased a 3-year discovery period under its existing D&O insurance program, which extended coverage for claims first made during the period May 31, 2000 to May 31, 2003.

The notice provision in the policy had been amended. The original provision required as a "condition precedent to coverage" that the insured provide notice of claim "as soon as practicable…but in no event later than ninety (90) days after such claim is made." The amended provision required "as a condition precedent" to coverage that the insured provide "notice, in writing, as soon as practicable of any claim first made against [the insureds] during the Policy Period, or Discovery Period (if applicable) but in no event later than ninety (90) days after the expiration of the Policy Period, or Discovery Period."

On November 28, 2001, FlashNet was named as a defendant in a securities class action lawsuit that was one of the many IPO laddering cases. Prodigy was served with a copy of the complaint on June 20, 2002.

Prodigy first communicated with the insurer by letter dated June 6, 2003, in which Prodigy sought the insurer’s consent under the policy to settlement of the securities case. The insurer responded that the June 6 letter failed to comply with the policy’s notice requirements. In reply, Prodigy sent a formal notice of claim on June26, 2003, which Prodigy claimed was timely because it was sent within ninety days of the May 31, 2003 expiration of the 3-year discovery period. The carrier denied coverage and Prodigy initiated an action seeking a judicial declaration of coverage.

Proceedings Below

The trial court ruled that Prodigy had failed to comply with the condition precedent to coverage and that this failure "avoids coverage, with or without prejudice to [the insurer]." The court of appeals affirmed, holding among other things that notice given almost one year after the lawsuit was filed was not "as soon as practicable," and that the insurer was not required to proved that it was prejudiced.

The Majority’s Opinion

Chief Justice Wallace B. Jefferson’s opinion for the majority framed the question before the court as "whether, under a claims made policy, an insurer can deny coverage based on its insured’s alleged failure to comply with a policy provision requiring that notice of claim be given ‘as soon as practicable’ when (1) notice of claim was provided before the reporting deadline specified in the policy; and (2) the insurer was not prejudiced by the delay."

The majority did not consider it determinative that notice as "as soon as practicable" was identified in the policy as a "condition precedent" to coverage. Rather, the Chief Justice wrote, in order to determine whether or not a showing of prejudice is or is not also required in order for the insurer to assert late notice as a defense to coverage, the question is whether the "notice as soon as practicable" language was "an essential part of the bargained-for exchange in the claims made policy at issue."

After reviewing the role of the notice provisions within claims made policies generally, the Chief Justice concluded that the insured’s obligation to provide notice "as soon as practicable" was "not a material part of the bargained-for exchange," and further concluded that "in a claims-made policy, when an insured gives notice of a claim within the policy period or other specified reporting period, the insurer must show that the insured’s noncompliance with the policy’s ‘as soon as practicable’ notice provision prejudiced the insurer before it may deny coverage."

Therefore, because the insurer had admitted that it was not prejudiced by the delay in receiving notice, the majority held that the insurer could not deny coverage based on Prodigy’s failure to provide notice as soon as practicable.

The Dissenting Opinion

The dissenting opinion, written by Justice Phil Johnson and joined in by two other justices, asserted that "today the Court rewrites an unambiguous insurance contract and changes the agreement of the parties." Justice Johnson wrote that "the record does not show as a matter of law that the notice language was not essential to the parties’ agreement," adding that "the Court’s conclusion otherwise is in derogation of the parties’ intent as expressed by the policy language."

Justice Johnson added that "there is no basis in the record for concluding that Prodigy’s one-year delay in reporting the claim was any more or less important to [the insurer’s] insurance business than if Prodigy had delayed for a year reporting a claim made on the last day of the Discovery Period."

Discussion

If nothing else, the majority opinion in this case confirms the frequent observation that courts disfavor insurance coverage denials based on late notice defenses. The general reluctance of courts to recognize notice defenses is based on an apparent perception that a policy notice requirement can operate like a "gotcha" to cut insureds off from the policy coverage for which they paid and to which they would have been entitled if notice were timely – and if the carrier is not prejudiced by the late notice, well then, no harm, no foul, right?

But even allowing for these assumed biases, the majority’s opinion’s disregard of the policy’s explicit "condition precedent" language and its own determination that the "as soon as practicable" language was "not a material part of the bargained for exchange" are both discomfiting.

Some perspective seems in order here. Not only was Prodigy’s notice to the insurer delayed by nearly a year, but Prodigy’s first contact with the insurer was a request for settlement consent. At some level, these facts exemplify the very kinds of circumstances to which insurers will sometimes refer in attempting to explain why notice provisions are necessary.

It may well be objected that if the insurer was not prejudiced by the delay here, what difference did the one-year delay really make? The typical insurer answer to this question is that they don’t want to get caught up in sometimes complicated and potentially fraught debates about whether or not a delay prejudiced their interests. After all, what really constitutes prejudice? What has to shown to establish prejudice? Rather than having to debate these kinds of fact intensive and divisive issues, the insurers prefer certain bright line tests that specify the minimal requirements under certain circumstances.

On the other hand, the policy language itself may have preordained a policyholder friendly outcome here. The notice provision the court was interpreting had in fact been amended to make it more policyholder friendly, by substituting the more flexible "as soon as practicable language" for the policy’s base form requirement of notice within a specified number of days.

The question is whether the majority opinion’s ruling represents more of a policyholder friendly outcome than the insurers may have thought they were offering with the more flexible language – an outcome that may in the future constrain the insurers’ willingness to offer the flexible language and encourage them to insist on more rigid alternatives as reaction to this kind of outcome. A more rigid approach could in turn lead to more questions about the timeliness of notice and potentially to more coverage disputes.

All of that said, and knowing full well how devastating any coverage denial can be to policyholders, and how some clerical or administrative error potentially could produce notice problems that otherwise might leave policyholders in the lurch, there arguably is some fundamental fairness to the judicial system’s chronic suspicion of notice defenses. Viewed in that light, the outcome in the Prodigy case is at least understandable, even if the majority opinion itself could be unsettling in certain respects.

Special thanks to the several readers who provided me with copies of the Prodigy opinion.

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Private equity firms and the funds they organize frequently place individuals on their portfolio companies’ boards. However, all too frequently, it is not until a claim has arisen that the various entities consider how the potentially implicated indemnities and insurance will interact. Unanticipated interactions sometimes can produce unintended consequences, particularly from the perspective of the private equity firm.

A March 19, 2009 article by the Latham & Watkins firm on the Harvard Law School Corporate Governance Forum blog entitled "Indemnification of Director-representatives by PE Firms" (here) takes a closer look at these issues.

Among other things, the authors note that "the allocation of responsibility for indemnification and advancement obligations … are not considered until after litigation has been filed" and the same "holds true with respect to the amount of available insurance, especially at the portfolio company level."

The authors offer a number of excellent practical suggestions.

First, they suggest that the contractual arrangements between the private equity firm and the individuals serving on the portfolio company boards "provide clearly that the private equity firm’s indemnification and advancement obligations to its director-representatives are secondary to the indemnification and advancement obligations of the portfolio company." Otherwise, courts may consider the private equity firm and the portfolio company to be "co-equally liable," which could prove very costly for the private equity firm if it advances costs in the first instance and later seeks reimbursement from the portfolio company.

Second, the authors suggest that if the indemnification documents with the director-representative cannot be modified, the private equity firm "should seek an assignment of the director-representative’s rights to indemnification and advancement from the portfolio company prior to the fund paying out defense or settlement costs on their director-designees’ behalf."

Third, the authors point out that advancement rights are distinct from indemnification rights, and they suggest that the portfolio company’s advancement commitments "should be examined to be certain that advancement is contractually required and that any advancement obligations owed by the private equity firm or its fund are secondary to the obligations of the portfolio firm."

The authors’ final observations relate to insurance. They comment that typically "neither the director nor the private equity firm will look at the portfolio company’s D&O insurance policies until after the director needs to defend/or settle such claims."

The authors correctly note that the private equity firm should review the portfolio company’s policies to ensure that the policies are "adequate to protect their director-representatives." The authors also suggest a review of the provisions that will determine how the portfolio company’s policies and the private equity firm’s policies will interact in order to "prevent a battle of the insurance companies."

The authors cite the interaction between the portfolio company’s D&O insurance policy and the private equity firm’s policy as a potential concern. These insurance issues become particularly critical if the portfolio company goes bankrupt, in which case portfolio company indemnity issues drop out of the picture and the portfolio company's insurance can becomes critical.

Bankruptcy often has a way of demonstrating the insufficiency of the limits of insurance that the portfolio company purchased. Moreover, bankruptcy also has a way of demonstrating –after the fact – the need for auxiliary insurance structures (such as Side A/DIC insurance or independent director insurance) to protect individuals in the event of complex claims while the portfolio company is bankrupt.

The authors are correct that the the various potentially implicated insurance policies terms and prospective insurance interactions all too often go unexamined. However, looking at the terms alone is not enough. Limits selection and program structure should also be carefully considered. Private equity firms should take steps to ensure that the portfolio company’s insurance program will sufficiently protect the director-representatives in all contingencies, even bankruptcy—or, rather, especially in bankruptcy.

I disagree with the article’s authors on one point. The authors state that "private equity firms should also strongly consider having the same carrier write the primary policies at both the firm and at each of its portfolio companies." The authors suggest this approach avoids the "other guy’s" policy coverage dodge.

The authors are correct that this would avoid the "not my problem" dodge. But it could be a terrible insurance solution in every other respect, both for the private equity firm and for the portfolio companies. First, from the private equity firm's perspective, there are relatively few carriers willing to write those kinds of risks in the first place, and within that small group, the available terms and conditions vary dramatically. The private equity firm should focus first on placing the optimal insurance solution for its own risks and needs, without being forced to accept a suboptimal solution out of an artificial effort to try to match carriers with its portfolio companies.

By the same token, the portfolio companies are unlikely to have uniform exposures and interests. Given the incredible diversity of potential insurance alternatives available in the marketplace, it is very unlikely that the same carrier would provide the best insurance solution for each of the various portfolio companies. And by the same token, the portfolio companies should not have their range of potential D&O insurers restricted only to the relatively few carriers that also will write private equity firm D&O insurance.

In short, trying to cram all of the various insured entities under a single carrier’s umbrella could address one single issue but create a host of potentially more significant problems as a result. The preferred approach is exactly the one the authors otherwise recommend, which is to consider policy interaction issues in connection with the insurance placement process – a process that should in the first instance be addressed to providing the best solutions for each respective entity.

The authors’ interesting article highlights the need for private equity firms to enlist knowledgeable and experienced insurance professionals in connection with their insurance placement and in connection with their consideration of the issues discussed above. Insurance can sometime appear like a peripheral or relatively unimportant matter-- unless things go seriously wrong, in which case insurance can turn out to be the most important thing. At the point that things have gone seriously wrong it a very poor time to discover that critical insurance issues were insufficiently considered.

Break in the Action: The D&O Diary is taking its act overseas, and so the publication schedule will be disrupted for the next few days. Regular publication will resume the week of March 30.

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The current global financial crisis may result in "unprecedented levels of litigation" that "will either serve to identify ‘weak links’ in the chain of participants who originate, appraise, and service collateral and underwrite, manage, insure, rate and sell securities," or it will serve to "highlight where the market may have underappreciated certain risks or failed to appreciate certain circumstances," according to a paper featured in a March 17, 2009 post (here) on the Harvard Law School blog.

The paper, entitled "Legal and Economic Issues in Litigation Arising From the 2007-2008 Credit Crisis," was written by Babson College Professor Jennifer Bethel, Harvard Law Professor Allen Ferrell, and Babson Professor Gang Hu, can be found here.

The paper explores the "economic and legal causes and consequences of the 2007-2008 credit crisis." In particular, the paper examines "the risks that can arise from financial and technology innovations and losses that are uniquely related to correlated events in the setting of loan markets." The paper sets for a detailed and interesting overview of the economic and financial causes that contributed to the current credit crisis.

The paper also notes that "the credit crisis is not solely an economic phenomenon, but a legal one as well." The paper discusses a number of different types of lawsuits that have arisen, but focuses in particular on securities class action lawsuits against public companies, which the paper describes as "by far the most important litigation likely to arise out of the credit crisis."

The paper asserts that "plaintiffs that bring Rule 10b-5 class action lawsuits will face substantial challenges," and notes in particular that the securities plaintiffs will have to navigate around three basic legal principles: "(i) there can be no ‘fraud by hindsight’; (ii) there can be no actionable disclosure deficiency with respect to information the market already knew (the ‘truth on the market’ defense); and (iii) plaintiffs must establish loss causation for their claims."

First with respect to the "fraud by hindsight" concern, the paper notes that it will not be enough for plaintiffs to show that there have been economic losses; they will also have to show that the adverse developments were reasonably foreseeable at the time the supposedly disclosures were made. The authors note that

Whether a failure of certain market participants to provide detailed disclosures regarding the implications of an event – the first full national fall in housing prices since World War II in conjunction with a dramatic and increasingly global crisis – from which the actors themselves suffered huge losses is actionable will likely prove an important stumbling block, in our judgment, for a number of actions being brought.

The authors add that "the presence of disclosure failures and materiality thereof must be assessed in light of what was known at the time of the disclosures without the benefit of 20/20 hindsight, even if losses occur."

Second, with respect to the "truth on the market" defense, the authors question whether the target companies in fact had "special knowledge that was not known by the market at large." The authors suggest that this may have been a situation where the market was at least as informed, or at least no less informed, than the defendants on relevant issues.

Third, the authors suggest that "loss causation is likely to be a challenging litigation issue for plaintiffs, because market prices, especially of financial-sector securities, declined overall."

The few dismissal rulings that have accumulated so far provide at least some support for the authors’ theories. In at least two cases where dismissal motions have been granted with prejudice – the NovaStar Financial case (about which refer here) and the Impac Mortgage case (refer here) – the courts seemed particularly concerned that the defendant companies had been caught in an industry-wide or even economy-wide downturn. Even if the courts did not use the price phrase "fraud by hindsight," the concept was seemingly implied in the rulings.

At the same time, however, there have also been significant cases where courts have had no difficulty denying dismissal motions – for example, New Century Financial (refer here) and Countrywide (here) – in which the courts have expressed open outrage regarding the alleged misrepresentations and omissions. The authors’ analysis seems deficient to me to the extent it fails to recognize the possibility that at least some courts’ judgments potentially may be affected by this sense of outrage, particularly over the extent of damage done, to investors and to the economy. (A list of all of the subprime dismissals and dismissal motion denials can be accessed here.)

In addition, given the authors overall hypothesis that plaintiffs will face substantial hurdles in pursuing these cases, it seems a noteworthy and even odd omission that the authors detailed and exhaustive paper neglects to even mention the possibility that the U.S. Supreme Court’s decision in the Tellabs case could also represent a significant hurdle for the plaintiffs. In that regard, the Tellabs decision has generally proven instrumental in those cases where dismissal motions have been granted thus far.

Finally, with respect to the authors’ suggestion that loss causation issues may prove critical, I note that in a prior post (here) I discussed the challenge that plaintiffs may face where they have sued for supposed economic losses on securities that continue to provide scheduled interest payments on time and in full. These arguments may be particularly relevant in claims brought by mortgage-backed securities investors who have sued the securities issuers and the securities offering underwriters.

Defenseless: Laura Pendergast-Holt, the erstwhile Chief Investment Officer of Stanford Financial Group, has a few legal problems to sort out. First, she is a defendant in an SEC enforcement proceeding involving the Stanford Group. Second, she was arrested on February 26, 2009 and charged with obstructing a proceeding before an agency of the United States. Third, she has been named as one of the defendants in numerous civil lawsuits brought by irate Stanford group investors. (A complete list of Stanford-related litigation can be accessed here.)

Ms. Pendergast-Holt clearly needs the services of an attorney. Unfortunately, she is also party to one more lawsuit, one in which she is the plaintiff, and which suggests the challenges she may have in providing for her legal representation in the above matters.

On March 17, 2009, she filed a lawsuit in Texas (Dallas County) District Court against Stanford Group’s directors and officers’ liability insurer, alleging that the insurer has "failed and refused to provide a defense so that she can defend herself in the SEC action, the civil class action, and in the criminal matter." A copy of her Original Petition can be found here.

Ms .Pendergast-Holt seeks a judicial declaration of coverage. Arguing that she has no way of satisfying any self-insured retention, she also seeks a "declaration that any self-insured retention or deductible be waived, held inapplicable or enjoined." She also alleges breach of contract and bad faith. She seeks damages estimated to exceed $5 million, as well as punitive damages estimated to exceed $40 million.

The bases on which the insurer has declined coverage for Ms. Pendergast-Holt’s defense are not specified in her Original Petition. While the scandal surrounding Stanford Group is notorious, as yet there have been no verdicts and no guilty pleas, nor to my knowledge have there even been any admissions. Whatever the facts ultimately prove to be, nothing has as yet been determined. These considerations may prove relevant to the coverage dispute, for example, with respect to the potential applicability of policy exclusions. On the other hand, representations made in connection with Stanford’s policy application (particularly with respect to Stanford’s finances) may also figure into the insurer’s coverage position.

A March 18, 2009 AmLaw Daily post regarding the coverage lawsuit can be found here. Hat tip to the Courthouse News Service (here) for a copy of the Original Petition.

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Last fall, the New York Department of Insurance ignited a firestorm when it issued an opinion that a D&O insurance policy may not place the duty to defend on the insured. As I discussed in an earlier post (here), the opinion is contrary to both the uniform practice of the D&O insurance industry and the unambiguous preference of public company D&O insurance buyers.

On February 26, 2009, following his keynote address at the the Professional Liability Underwriting Society (PLUS) D&O Symposium, New York Insurance Superintendent Eric Dinallo acknowledged the industry’s reaction to his department’s opinion, and indicated that the department would reconsider the issue and address it through the issuance of a new regulation. He also invited the industry to help his department to shape the new regulation.

Based on the Superintendent’s invitation, PLUS is now working with the American Insurance Association (AIA). The AIA has drafted proposed revised regulatory language that is now being circulated among its members. PLUS has also invited its member companies to comment on the draft regulatory proposal. PLUS will compile the comments and share them with the AIA and the New York Department of Insurance.

One representative from each PLUS member company can obtain a copy of the draft proposed regulatory language by contacting PLUS’s Executive Director, Derek Hazletine, dhazeltine@plusweb.org.  

I am setting all of this information out in a separate blog post because the deadline for comment to be received is next Monday, March 23, 2009, so companies that want to participate will have to move quickly.

In his Feb. 26 presentation, Dinallo indicated that he intends to act quickly on the proposed regulations and that he hopes to have the regulations in place by late spring.

Insurers Must Disclose Climate Change Exposures: On March 17, 2009, the National Association of Insurance Commissioners adoped a "mandatory requirement that insurance companies disclose to regulators the financial risks they face from climate change, as well as the actions the companies are taking to respond to those risks." According to the NAIC's press release (here), all insurance companies with annual premiums of $500 million or more will be required to complete an annual Insurer Climate Risk Disclosure Survey with an initial deadline of May 1, 2010. 

In the Survey, insurers will be required to report on "how they are altering their risk-management and catastrophe risk moedline in light of the challenges posed by climate change" and they will also be required to report  on "steps they are taking to engage and education policymakers and policyholders on the risks of climate change" as well as "whether and how they are changing their investment strategies." 

These reporting requirements could have a singificant impact, not just on insurers disclosures, but on their conduct as well. The requirement to disclose what the carriers are doing to "engage and educate" policymakers seems to suggest that the NAIC expects carriers to become proactive on the legislative and regulatory front regarding climate change. The disclosure regarding investment strategies potentially could influence insurers'' investment decisions. The clear implication of the NAIC's rule is that the regulators expect the disclosure requirements will motivate the carriers to become proactive in these areas.

The web page for the NAIC's Climate Change and Global Warming Task Force, including a link to the draft language of the new disclosure requirements, can be found here.

The Hits Just Keep on Coming: Bernard Madoff may now be in jail following his recent guilty plea, but that does not seem to have slowed the flow of new Madoff-related lawsuits. As the new suits have come in, I have added the new suits to my running tally of the Madoff-related litigation, which can be accessed here.

The litigation register has now grown to be quite lengthy. Madoff’s fraudulent scheme may have cost investors billions, but he has stimulated a heaping stack of litigation.Special thanks to the many readers who have been sending me the new complaints as they have come in, especially Jon Jacobson of the Greenberg Traurig law firm. Readers may be interested to know that Jon is also reporting on the new cases on Twitter (here) as they come in.

Speaker’s Corner: Next week I will be in London speaking at the C5 D&O Liability Insurance Conference. The specific panel on which I will be speaking is entitled "Current Litigation Trends in Europe and the U.S.: Are Class Actions on the Horizon?" The conference, which will take place March 24 and 25, 2009 at the Grange City Hotel., will feature a diverse array of speakers on a wide variety of D&O insurance related topics. The entire program agenda can be found here.

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

Background

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

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

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

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

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

Recent Case Examples

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

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

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

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

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

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

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

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

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

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

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

Discussion

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

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

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

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

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

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

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

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

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

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

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

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On March 2, 2009, in an opinion with important implications for the availability of coverage when a company official has inculpatory knowledge at the time of policy formation, Judge Gerald Lynch of the Southern District of New York granted the motions for summary judgment of two of Refco’s excess D&O insurers, but denied the summary judgment motion of a third excess insurer. The reasons both for the grants and the denial are instructive, particularly with respect to the interplay between varying excess forms and the language of the primary policy. A copy of the March 2 opinion can be found here.

Background

As reflected in prior posts regarding this case (here and here), this coverage dispute relates to the D&O insurance Refco procured in connection with its ill-fated August 2005 IPO. Refco’s $70 million insurance program was arranged in multiple layers, with a primary carrier and several excess carriers.

The $70 million program was arranged as follows: A primary $10 million layer; a first level excess layer of $7.5 million excess of the primary $10 million; a second excess layer of $10 million excess of the underlying $17.5 million; a third excess layer of $12.5 million excess of the underlying $27.5 million; a fourth excess layer of $10 million excess of the underlying $40 million; and a fifth excess layer of $20 million excess of $50 million. UPDATE: According to the remarks posted by an anonymous commentator, the fifth level excess policy is a Side A/DIC policy.

In October 2005, two months after Refco’s IPO, it was revealed that at the time of the IPO, Refco had an undisclosed $430 million receivable due from an entity controlled by Refco’s CEO, Phillip Bennett. Following this revelation, the company collapsed. Bennett, among others, has pled guilty to an array of criminal offenses.

Following Refco’s collapse, the company’s directors and officers were the target of extensive litigation. The primary and first level excess carriers advanced their entire combined limits of $17.5 million in payment of defense expense, subject to repayment if it is determined that there is no coverage. The four remaining excess carriers initiated litigation seeking a judicial determination of no coverage under their policies. In a June 18, 2008 opinion (here), Judge Lynch denied the second level excess carrier’s motion for summary judgment and in a subsequent opinion (here) determined that the second level excess carrier had an obligation to advance the payment of defense expense while the coverage issues were pending.

The March 2 Opinion

Judge Lynch’s March 2 Opinion relates to the motions for summary judgment of the third, fourth and fifth level excess carriers. Judge Lynch granted the motions of the third and fourth level excess carriers but denied the motion of the fifth level excess carrier.

The difference in outcome turned significantly on important differences between and among the excess policies each of the three carriers had issued to Refco. The third and fourth level excess policies were so-called "follow form" policies, meaning they followed the terms and conditions of the primary policy, except to the extent that their excess policies expressly adopted additional or different terms and conditions. The fifth level excess policy was not a follow form policy, a distinction that proved to be outcome determinative, at least for purposes of the summary judgment motions.

Each of the three policies had their own exclusionary provisions (not found in the primary policy) precluding coverage for claims arising from any facts or circumstances of which any insured had knowledge at policy inception and that might reasonably be expected to give rise to a claim. (The relevant exclusions were described in the third and fourth level excess policies as "prior knowledge exclusions" and as an "inverted representation endorsement" in the fifth level excess policy.)

Although he took some time getting there, in the end Judge Lynch had little trouble concluding that Bennett’s knowledge of the undisclosed receivable at the time of policy formation triggered these knowledge exclusions. The critical question was whether or not Bennett’s knowledge and the operation of the exclusions precluded coverage for all of the other insureds in light of the applicable policy terms and conditions.

The availability of coverage for the other insureds in turn depended on the operation of the applicable "severability language." This language determines whether or not the knowledge of one insured can be imputed to another.

Because the third and fourth level excess insurers’ policies are "follow form," the severability language on which the insureds relied to argue that Bennett’s knowledge was not imputable to them was from the primary policy. By contrast, because the top level excess policy was not a follow form policy, but instead had its own severability language, the insureds relied on the top level policy’s language in arguing for coverage under that policy.

After a lengthy discussion whether or not the primary policy’s application severability provision applied to the excess insurer’s exclusions, the court concluded that in the end the question didn’t matter. (See the following section for the distinction between application severability and exclusion severability.) Judge Lynch concluded that, under the policies’ terms, the addition of the knowledge exclusions to the third and fourth level excess policies "superseded" any contrary language in the primary policy, including the primary policy’s severability provisions.

Since the knowledge exclusions the third and fourth level excess policies precluded coverage where any insured has knowledge of the existence of facts giving rise to the claim, Judge Lynch concluded that Bennett’s knowledge of the receivables scheme precluded coverage for all of the insureds under the third and fourth level excess policies.

By contrast, however, Judge Lynch concluded that "a number of facts unique to [the top level excess insurer] preclude granting summary judgment to the insurer." The critical distinction is that the top level excess policy had its own severability provision, which, because it was in the same policy, was not superseded by the presence of the knowledge exclusion.

In addition, the top level excess insurer’s severability language lacked a critical sentence that the primary policy’s severability language included. The severability provision in the primary policy contained, but the top level insurer’s severability provision lacked, the following final sentence: "If any particulars or statement in the Application is untrue, the Policy will be void as to any Insured who know of such untruth." Because the top level excess insurer’s policy had no such provision, which specifically linked the severability language to the application, Judge Lynch concluded that the top level insurer "had not met its burden of showing" that its severability provision applied only to the application and not also to exclusions.

The Distinction Between Application and Exclusion Severabiltiy

A critical point to try to understand what is going on in this opinion is the distinction between application severability (that is, whether or not one person’s knowledge of application misrepresentations will be imputed to other persons) and exclusion severability (that is, whether or not one person’s knowledge or actions can be imputed to another for purposes of an exclusion).

Many practitioners will likely share my puzzlement that the decision almost entirely involves the question of the arguably more general operation of application severability provisions, even though the insurers were not relying on application misrepresentations to deny coverage, but rather upon the operation of the knowledge exclusion.

The explanation is that the excess policies apparently had no exclusion severability language of their own. Since the top level excess policy was not follow form and the excess policy has no exclusion severability language, the insureds relied on the arguably generalized operation of the application severability language to contend that Bennett’s knowledge could not be imputed to them for purposes of the exclusion.

The primary policy did, in fact, have its own exclusion severability language. However, Judge Lynch concluded (in a footnote) that because of the way the primary policy’s exclusion severability provision was worded, it applied only to the exclusions in the primary policy, and not to the distinct exclusion in the excess policy. Judge Lynch found that because the primary policy’s exclusion severability language applied only to the "above exclusions," it applied only to those found (that is, literally appearing "above") in the primary policy.

Discussion

If nothing else, this case provides an object lesson of the complicated way that the various components of a single D&O insurance program can operate to produce disparate results.

The so-called "follow form" policies wound up following neither the application severability nor the exclusion severability language of the primary policy, not because the excess policies expressly disclaimed those provisions, but simply because of the way the various policies interacted with each other. This opinion certainly highlights the truly limited extent to which "follow form" excess may actually follow form.

The extension of the excess policies’ knowledge exclusions to persons without knowledge is likely to trouble at least some observers. For most of the last decade, the D&O insurance industry has struggled to try to ensure that "innocent insureds" do not lose their insurance protection due to the misconduct or misrepresentations of others . The efforts to avoid these problems have concentrated on developing application and exclusion severability language limiting the consequences from the bad actors’ misconduct to the bad actors themselves.

This opinion illustrates an issue that may not have been a part of these industry efforts to create policy mechanisms to protect innocent insureds --  that is,  the importance of clarity of the purpose and design of application and exclusion severability provisions not just at the primary level, but all the way up the tower.

Another factor in this opinion not touched on above was the uncertainty whether or not the knowledge exclusions were even part of the excess policies. In addressing this issue, Judge Lynch reviewed the communications surrounding the placement of the insurance coverage. In my view, there was nothing unusual about these communications, which reflect nothing so much as the short time frame within which these kinds of insurance programs often are put together. But while the communications themselves are not out of the ordinary, the questions that subsequently have arisen do highlight the pitfalls of the policy procurement process.

Among other things, the process (at least to the extent reflected in Judge Lynch’s opinion) seems to suggest that in connection with the placement of the excess policies, the company’s representatives accepted the knowledge exclusion in lieu of an increased limits application. The practitioners’ pointer from this case is that severability is an equally important issue with respect to the exclusion as it would be to the increased limits application. This case suggests that in order to determine whether or not the severability issue is appropriately addressed entails consideration not only of the specific exclusionary language but also consideration of the interaction of all of the pieces in the tower.

The other specific practitioners’ pointer is that the exclusion severability language in a primary policy can be (and in this case, was) worded so as to restrict exclusion severability solely to the primary policy, without effect on any exclusions that may be added in any excess policies and regardless whether or not the excess policies otherwise are follow form policies. This observation suggests the need to specifically consider the question of exclusion severability in the context of any exclusions added to excess policies.

I wish to emphasize that nothing in these observations should be taken in any way as a criticism of anyone involved in the Refco coverage placement. This case demonstrates how complicated the interaction of the various program components can be, and that the interaction of the components can even, as this case demonstrates, produce results that might not be anticipated at the time of policy placement.

One final thought has to do with the fact that the court granted summary judgment for the third and fourth level excess insurers but not for the top level insurer. There has not at this point been any determination that there is coverage under the top level insurer’s policy. But if there were, I wonder whether the court’s entry of summary judgment on behalf of the third and fourth level excess insurer would create a gap in coverage that would relieve the fifth level excess insurer from its payment obligations – or rather, because the coverage underlying the fifth level of coverage will not be exhausted by payment of loss, could the fifth level excess carrier’s policy even be triggered? Obviously, the specific trigger language in the fifth level excess policy could be critical on this issue, but I suspect that before all is said and done the argument that there is a coverage gap will come up.

A March 3, 2009 memo from the Wiley Rein law firm discussing the Refco opinion can be found here. The Wiley Rein memo discusses a number of other important aspects of this opinion that I have not addressed above. Special thanks to the several loyal readers who sent me a copy of the opinion.

The Marc Dreier Scandal: The subsequent and much larger Madoff and Stanford Financial scandals have driven the Marc Drier scandal into the background, but the Dreier scandal is in some ways even more astonishing than those larger cases. A truly fascinating account of Marc Drier’s manic passage from hyper-aggressive lawyer to identity-misrepresenting fraud is set out in a March 3, 2009 American Lawyer article entitled "Anatomy of a Crack-Up: The Marc Dreier Case" (here). Alison Frankel’s comprehensive retelling of Drier’s disturbing tale makes for compelling reading.

We Don’t Need No Stinking TARP Money: According to a March 3, 2009 CFO.com article (here), a number of regional banks have concluded they are better off without TARP money. The article cites, for example, TCF Financial Corp, a Minnesota-based bank holding company with $16.7 billion in assets which claims that it only took the money ($361.2 million) under government pressure.

The article quotes the company’s CEO as saying that "the rules have definitely changed," and that whereas at the outset the message had been that only healthy banks would be granted the funds, subsequent Treasury actions and congressional mandates have created a "public perception" that banks that took TARP money "did so out of weakness." The CEO says that this perception puts the bank at a "competitive disadvantage."

The government recovery program is in trouble if bankers become convinced there is a stigma associated with accepting government aid. Part of the problem for the banks undoubtedly is the grandstanding politicians who insist on attempting to aggrandize themselves by flaying anyone receiving government aid. Even if some (but definitely not all) bankers made a hash of it in recent years, do we really want Congress trying to tell banks what to do?

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Deteriorating economic conditions threaten a massive wave of corporate defaults. Corporate borrowers’ inability to fulfill debt obligations not only could prompt a bankruptcy filing surge, but also could result in a flood of ensuing lawsuits and claims as creditors and shareholders seek to recoup their losses. These claims could present a host of challenging D&O coverage issues.

The Growing Default Threat

According to a February 13, 2009 Wall Street Journal article entitled "Wave of Bad Debt Swamps Companies" (here), "the U.S. is entering a period likely to feature the most corporate-debt defaults, by dollar amount, in history." The article reports estimates that "U.S. companies are poised to default on $450 billion to $500 billion in corporate bonds and bank loans over the next two years."

In percentage terms, the default rate could "approach levels last seen in 1933." High yield default rates peaked around 15% in 1930. The Journal reports that S&P estimates that default rates will hit 13.9% this year "but could go as high as 18.5% if the downturn is worse than expected."

The "growing wave of souring debt" has already resulting in rising numbers of bankruptcies, including, just in the last few days, Muzak Holdings LLC; Pliant Corp.; Aleris International; and Midway Games.

However, as the Journal article observes, corporate defaults do not always result in Chapter 11 filings. Borrowers are sometimes able to restructure their debt outside of bankruptcy, and sometimes give creditors ownership stakes in exchange for reducing or elimination debt.

The Risk of Increased Numbers of Claims

In addition to the possibility of a growing number of bankruptcies, the prospect of surging corporate defaults also raises the possibility of an upsurge in claims against the directors and officers of the struggling or bankrupt companies.

Companies whose financial stability is deteriorating may as one consequence of their struggles get hit with a "going concern" opinion from their auditor. As the securities lawsuit filed against NextWave Wireless illustrates, the question whether a company can continue as a going concern alone can become an allegation in a shareholders’ class action complaint.

Claims may arise even when companies attempt a work out to try to avoid bankruptcy. These claims can come from shareholders, who may content that the workout resulted in a dilution of their interests, or it can even come from other bondholders, who may claim that their interests have been harmed or improperly subordinated, as demonstrated in the recent Station Casino bondholder claim (complaint here). Bondholders also recently filed a similar lawsuit against Harrah's Entertainment and certain of its directors and officers (refer here).

But a bankruptcy filing is particularly likely to be followed by claims against the bankrupt company’s directors and officers. These claims can come in the form of securities lawsuits brought against the individuals by the bankrupt company’s shareholders, as reflected for example in the recent cases filed against Pilgrim Pride’s corporate officials (refer here); against Britannia Bulk’s senior officers (here); or against the directors and officers of Charys Holding Company (here).

In addition, the Trustee in bankruptcy may also assert claims against the company’s directors and officers, as evidenced in the now infamous Just for Feet claim (about which refer here). As the Just for Feet bankruptcy also demonstrates, these various claims can arise simultaneously, which presents its own set of issues.

The Potential Coverage Issues

The advent of claims following bankruptcy presents a number of challenges in the context of any potentially applicable directors and officers’ liability insurance. Some of these challenges are a reflection of the size and structure of the insurance program; other challenges arise from the nature and extent of the coverage afforded.

With respect to the overall program, one critically important issue may simply be the amount of insurance available. The prospect for multiple simultaneous claims is increased dramatically when a company files for bankruptcy. The simultaneous prosecution of multiple claims presents the very real possibility that the insurance could be substantially depleted or even entirely exhausted. As demonstrated in the claims surrounding the Collins & Aikman bankruptcy (about which refer here), defense costs alone potentially could deplete the available limits.

And as demonstrated in connection with the multiple claims filed against the directors and officers of Just for Feet following that company’s bankruptcy, the proceeds of a traditional D&O insurance program alone may be insufficient to resolve all claims that can arise in the bankruptcy context. Both the Collins & Aikman and the Just for Feet examples have important implications for policy structure, as discussed below.

The interplay between the provisions of the Bankruptcy Code and the terms and conditions of the D&O policy may present certain specific challenges. As I discussed at greater length in a prior post (here), a recurring issue since so-called "entity coverage" has become a standard part of the D&O policy has been whether or not the D&O policy proceeds are property of the bankrupt estate under Bankruptcy Code Section 541(a) and subject to the automatic stay in bankruptcy under Bankruptcy Code Section 362.

A particularly good article discussing these questions regarding the D&O policy proceeds and the operation of the bankruptcy stay written by my good friend Kim Melvin of the Wiley Rein law firm can be found here.

Another frequently recurring D&O insurance coverage issue arising in the bankruptcy context is whether claims asserted by the Trustee or other receivers or liquidators against the company’s directors or officers funs afoul of the policy’s exclusion for claims brought by one insured against another insured. The "insured vs. insured" issue arises because of the concern that the Trustee or other claimant is "standing in the shoes" of a policy insured, the company itself.

Addressing the Insurance Concerns

A number of policy solutions to these recurring bankruptcy issues have developed in recent years. For example, a coverage carve-back to the insured vs. insured exclusion, now a standard provision in most policies, has continued to evolve over the years to address concerns about coverage for claims brought by Trustees and others.

In addition, many policies now contain "priority of payments" provisions as a way to try to address questions surrounding the availability of the D&O policy’s proceeds for the payment of defense expense or the resolution of claims notwithstanding the bankruptcy stay.

Perhaps even more importantly, to address concerns about the susceptibility of the policy proceeds to depletion or exhaustion from multiple simultaneous claims, particularly in the bankruptcy context, the D&O industry has developed a number of structural solutions designed to ensure that whatever may happen, a fund of money will remain available for specified individuals so they can defend and resolve claims against them. These structures might take any one of a number of forms, including a so-called Side A/DIC policy, or even an individual director liability (IDL) policy.

The complexity of these coverage and structural issues underscores the need to involve a skilled insurance professional in the D&O insurance acquisition process. Financial troubled companies in particular require the contributions of an informed and experienced advocate in structuring their coverage. The structure and the terms and conditions of a company’s insurance program could determine whether or not insurance coverage is available for individual directors and officers in the event of bankruptcy and related claims.

One final note about the likelihood of increasing corporate defaults. That is, the current deteriorating economic conditions not only present challenges for insurance buyers, they also present serious concerns for D&O underwriters. As the Journal article cited above notes, the defaults "will likely spread across many industries." Among the industries the article specifically mentions are "media, entertainment, casino and hotel companies, car makers and retailers."

Up to this point, the most significant consequences of the credit crisis have been concentrated in the financial sector. D&O underwriters have had the ability to segment risk arising from the credit crisis according to whether or not companies were financially related. However, with the growing threat of corporate defaults across many industry sectors, risk segmentation will be much more challenging. At a minimum, it will no longer be sufficient for underwriters to presume that risk is limited to the financial sector alone.

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2008 was a remarkably eventful year, from the dramatic developments during the fall that rocked the financial markets to the changing of the guard in the Presidential election.  Many of the events had a profound impact in the world of D&O insurance.  In all likelihood, significant developments will continue to emerge during 2009 that will have implications for the D&O insurance marketplace.

In the latest issue of InSights (here), I review the past year’s most noteworthy events in the context of the D&O insurance marketplace.  The article’s first section reviews the top ten developments in the world of D&O insurance during 2008.  The article concludes with a perspective on what may lie ahead in 2009, including, in particular, a consideration of the impact that last year’s events could have on D&O pricing and coverage. 

A separate addendum to the InSights article takes a closer look at the 2008 securities class action lawsuit filings.As the addendum details, the pace of shareholder lawsuit filings increased significantly in 2008. There were 224 new securities lawsuits filed in 2008 , which represents a 30% increase over the 172 securities lawsuits filed in 2007, and an 88% increase over the 119 filed in 2006.

The 2008 filing total also represents the highest annual filing total since 2004. Further, all signs seem to indicate that the heightened filing levels will continue into 2009.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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As the details about the Satyam Computer Services scandal have emerged and the U.S. securities lawsuits have begun to flood in, questions have also arisen about Satyam’s D&O insurance. At least some of the questions are answered in a January 8, 2009 article in The Economic Times (India’s largest financial daily) entitled "Satyam Scam Triggers Biggest D&O Claim" (here).

According to the article, Satyam carries a $75 million D&O insurance program led by Tata AIG, which is a joint venture of Tata Group and American International Group. The article also states that the Satyam claim "could trigger one of the largest Directors and Officers insurance claims in India."

Of course, knowing the limits of liability under Satyam’s insurance program does not necessarily tell you how much insurance ultimately will be available to defend and indemnify Satyam and its directors and officers. In a case where the company’s Chairman has publicly admitted fraud, the applicable terms and conditions will be absolutely critical. I discuss below a couple of issues that seem likely to arise.

The Fraud Exclusion

Without knowing more about the specific terms applicable under Satyam’s D&O insurance program, it is difficult to say anything with certainty. However, at least in the U.S., D&O insurance policies do not cover fraudulent, criminal or intentional misconduct.

But, again in the U.S., these exclusions typically do not kick in until there has been an "adjudication." Even though Satyam’s Chairman has admitted cooking the books, he has not (yet) been convicted of anything, so to the extent the policy’s exclusions have an "adjudication" requirement, the exclusions would not apply, at least in the interim.

Moreover, a well-constructed U.S. policy would also contain a "severability of exclusions" provision so that even if an exclusion would apply to preclude coverage based on the Chairman’s misconduct, it would not apply to others who were uninvolved in the conduct. Of course, many questions are now being asked about who else at Satyam might have been involved in the fraudulent accounting. The Chairman’s letter sought to establish that other board members were unaware of the fraud.

A prior post discussing the "adjudicated fraud" exclusion can be found here. A separate post discussing an interim decision in the Refco matter and relating to the interaction of the exclusion and the funding of defense costs can be found here.

Application Misrepresentations?

Another insurance issue that likely will be raised is the question of policy rescission. Given the magnitude of the fraud and the apparent length of time during which it was going on, the question may be asked whether the policy was procured through misrepresentations in the application process.

Under the typical current D&O policy in the U.S., application misrepresentations can serve as a basis on which the carrier can rescind the policy only as to persons with knowledge of the misrepresentations and as to persons to whom that knowledge is imputed. A well-constructed U.S. policy will limit "imputation" so that innocent persons do not risk rescission of their coverage because of another’s misrepresentation. The imputation language used in Satyam’s policy could well be critical.

A prior post discussing D&O insurance policy rescission issues can be found here (refer especially to my "final thoughts" toward the end of the post).

I welcome any insight readers can provide about the provision of the typical D&O insurance policy in the Indian market, as well as any additional information anyone can supply about the Satyam program, particularly any additional carriers involved.

Very special thanks to loyal reader Aruno Rajaratnam for providing a copy of The Economic Times article as well as other information about Satyam.

Global Accounting Outlook = Bleak: Fitch's Ratings has issued a January 8, 2009 report entitled "Accounting and Financial Reporting: 2009 Global Outlook" (available here, registration required) with some very interesting observations about the year ahead for public company accountants. As the report states in its opening line, "these are indeed interesting times for accounting."

Among other things, the report notes the following with respect to the "going concern" questions that many companies and their accountants will face as the companies prepare their year-end 2008 financial statements:

The sharp decline in global debt and equity securities values and a very difficult credit environment have presented a unique set of chllenges to the interpretation and implementation of some pervasive accounting issues. An immediate question facing some companies preparing their full-year 2008 financial statements, is how best to justify a "going concern" basis, given the doubts some have about their abiltiy to refinance. Management statements on this issue should be required reading for investors and analysts. The determination of impairment charges on debt securities and the lack of clear-cut rules on the subject have pitted some issuers against their auditors. This is a particularly sensitive issue because profitability and regulatory capital adequacy are at state for many financial institutions.

Obviously, insurance companies are among the companies for whom the determination of impairment charges will be particularly sensitive. And among others who will want to read companies' managers' statements on the "going concern" issue, in addition to investors and analysts, are D&O underwriters.

A news article describing the Fitch report can be found here. Special thanks to a loyal reader for sending along the news article and a link to the report.

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The initiation of a criminal investigation against a company or its directors and officers can be a watershed moment in the life of any company. In addition to the question of how it will respond, the company must also determine how it will fund the associated legal expense. It is at this critical juncture that the company confronts issues surrounding the availability and limitation of D&O insurance in connection with criminal investigations.

These issues are explored in a December 2008 article by Patricia Bronte of the Jenner & Block firm entitled "D&O Coverage for Corporate Criminal Investigations" (here). As Bronte notes, the availability of coverage for a criminal investigation depends upon the particular language in the applicable policy, particularly the policy’s definition of the term "claim." The critical question will be whether or not the particular circumstances presented constitute a "claim."

The article opens with a review of case law from an earlier era, when D&O policies did not routinely define the term "claim." However, as the article discusses, the typical D&O policy now defines the term and includes within its definition a specific reference to a "criminal proceeding," which usually is further defined as having been "commenced by the return of an indictment."

One of the useful things Bronte’s article does is that by reviewing the early case law, she shows how the carriers came to insert the language limiting coverage for criminal proceedings to post-indictment matters. Prior cases where carriers were compelled to fund a wide range of expenses related to investigations and other pre-indictment matters clearly led to this change.

However, Bronte’s article also illustrates the difficulties, from the policyholder’s perspective, of this post-indictment limitation of coverage for criminal matters. That is, "a corporation’s best hope for a favorable outcome – and sometimes the best way to avoid disaster – is to persuade the prosecutor not to file any formal criminal charges at all."

As a consequence of this need to try to avert indictment, the corporation can incur considerable expense pre-indictment in respond to subpoenas, addressing a grand jury investigation, or otherwise attempting to answer the investigative threat. Costs incurred in connection with these efforts represent defense expenses, whether or the investigation ultimately results in an indictment.

Disputes over these kinds of legal costs are among the perennial battles in the D&O claims arena. Invariably, policyholders will argue that these expenses were indispensible to their post-indictment defenses, or even that they helped avert an indictment. Further complicating these discussions is the fact that these expenses associated with the pre-indictment criminal investigation often are being incurred at the same time that the company is also incurring legal expense in connection with an SEC investigation and also separate civil litigation. These various proceedings may be covered in whole or in part under the policy.

Because all of these various legal matters are going forward simultaneously and usually pertain to a single set of circumstances, sorting out which legal expenses relate to which proceeding (and therefore which expenses are covered under the policy) can become a vexing problem and source of tension between the policyholder and the carrier.

Exacerbating these problems is the fact that among all these proceedings, the criminal matter usually looms the largest and therefore may consume the larges amount of legal effort and expense. This is particularly true if, as is often the case, the individuals involved each retain separate counsel. The potentially massive expense associated with the criminal investigation underscores why these issues can be so critical.

In light of these considerations, the article offers some practical suggestions. Bronte notes:

Brokers and risk managers should press for "claim" definitions and coverage limits that adequately protect the corporate entity from the expense of criminal investigations, which almost inevitably involve multiple teams of lawyers defending the corporation and its employees.

In that regard, many D&O insurers now include within the definition of the term "claim" not only a reference to post-indictment (or post-information) criminal proceedings, but also a separate explicit reference to "investigations" (including criminal investigations), usually delimited in some way around the requirement for the naming of an insured person as a target of a possible indictment. The precise wording of the definitional provisions relating to "investigations" potentially could be critical.

In addition, at least one major carrier now has a form that removes any reference to an indictment requirement, and instead refers simply to "criminal proceedings." The removal of the indictment requirement, together with the reference to "proceedings," at least potentially opens the door to coverage for grand jury investigations, subpoenas, and other matters. While this alternative wording is not universally or even widely available, it does present an alternative for consideration.

The article also notes, in connection with efforts to secure coverage for criminal proceedings that "policyholders do not advance their position if they or their brokers characterize the criminal investigation as merely a ‘potential claim.’" An alternative possibility is to refer to the matters involved as a claim, or, in the alternative, a potential claim.

The article correctly points out that "the high cost of defending against accusations of criminal wrongdoing is one of the reasons that corporations purchase D&O insurance." Nevertheless, the extent of coverage for criminal proceedings remains one of the perennially disputed claims issues. The further development of D&O policy wordings that better address policyholder expectations is a continuing challenge for the D&O insurance industry and one on which there are fruitful areas for further discussion.

More About NERA’s Year-End Securities Litigation Study: In a prior post (here), I linked to NERA Economic Consulting’s year-end report on 2008 securities litigation activity. (The report itself can be found here). In a December 19, 2008 post (here), the Securities Docket has an interesting interview with the report’s authors, my good friends Stephanie Plancich and Svetlana Starykh. Among other things, the interview quotes the authors as saying, with respect to their projections for litigation activity in 2009:

While our paper does not forecast trends into the next year, our best guess is that filing activity will remain high into 2009. As mentioned above, there have been a number of new filings in late December — traditionally a slow time for litigation activity — indicating that the rate of filings has yet to decrease.

And while the first credit crisis cases were concentrated in the financial industry, there has been an emerging trend of credit crisis- and recession-related filings emerge outside of the financial sector.

Ghost of Christmas Preset, 2008 Version: With apologies to Charles Dickens, I excerpt below an imagined version of his holiday classic, updated for current circumstances. We can only hope that the Ghost of Christmases Yet-to-Come bears happier tidings. 

And taking Scrooge by the arm, the Spirit lifted him high above the financial landscape. Below him, Scrooge could see a parade of spectacles he scarcely could have imagined: the largest bank failure ever; the largest bankruptcy ever; the largest government bailout; the collapse of the housing market and the near-collapse of the entire financial system. 

"Spirit!" said Scrooge. "Show me no more! Conduct me home. Why do you delight to torture me?"

"One Shadow More!" exclaimed the Ghost.

And below, in the mist, Scrooge could see an avuncular man. Oddly and incongruously, the man wore a baseball cap. 

"Who is that man, Spirit?" Scrooge asked.

"Those who used to think of themselves as his friends called him ‘Bernie’" the Spirit said.

"No more!" cried Scrooge. "No more, I don’t wish to see it. Show me no more!"

Break in the Action: I think we could all use a break. I will discontinue my regular publishing schedule for the next few days. Regular publication will resume after the New Year.

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A December 15, 2008 opinion (here) in a Delaware bankruptcy court adversary proceeding provides a rare judicial interpretation of an "inadequate consideration" exclusion in a D&O insurance policy. I have reproduced with permission below a summary of the case prepared by the Wiley Rein law firm, followed by my own brief commentary. The firm’s case summary, which appears in the indented text below, can also be found here.

Case Summary

A federal bankruptcy court, applying New York law, has dismissed an adversary proceeding brought by a bankrupt home mortgage company against its directors and officers liability insurers, holding that coverage for a pre-petition lawsuit against the mortgage company was barred by application of an "inadequate consideration" exclusion. Delta Fin. Corp. v. Westchester Surplus Lines Ins. Co., Case No. 07-11880 (CSS) (Jointly Administered) (Bankr. D. Del. Dec. 15, 2008).  The court also held that the coverage dispute was a non-core proceeding.  Wiley Rein LLP represented one of the insurers in this case.

The underlying lawsuit arose from the mortgage company’s 2001 restructuring transaction.  In connection with that transaction, the mortgage company allegedly first convinced its unsecured and senior secured note holders to surrender their notes to a newly-formed holding company for which the note holders were granted certain interests in the holding company.  Next, the holding company returned the senior notes to the mortgage company, and, in exchange, the mortgage company transferred excess "cash flow certificates" to the holding company.  The mortgage company and the holding company intended that value of the exchanged senior notes and cash flow certificates would each be approximately $153 million.

In 2003, the former note holders filed suit against the mortgage company and its directors and officers alleging that, at the time of the restructuring transaction, the cash flow certificates had an actual fair market value of only $43 million.  The plaintiffs ultimately asserted eight causes of action against the defendants concerning various aspects of the restructuring transaction.  The mortgage company tendered the suit to its directors and officers liability insurers, and the primary insurer denied coverage based in part on the inadequate consideration exclusion.  In 2007, the mortgage company filed for Chapter 11 and brought an adversary proceeding against the insurers seeking damages and a declaratory judgment that the insurers were obligated to advance defense costs and provide indemnification for the underlying lawsuit.

In considering the insurers’ motions to dismiss, the bankruptcy court focused on the primary policy’s inadequate consideration exclusion, which provided that "[t]he insurer shall not be liable for Loss on account of any Claim made against any Insured: . . . based upon, arising out of, or attributable to the actual or proposed payment by the Company of allegedly inadequate or excessive consideration in connection with the Company’s purchase of securities issued by any company."  Noting that New York courts rely on a "but for" causation test to interpret insurance exclusions with "arising from" lead-in language, the bankruptcy court conducted a three-part analysis to determine whether the pre-petition lawsuit was excluded by the inadequate consideration exclusion. 

First, the bankruptcy court noted that each of the plaintiffs’ eight causes of action sought damages related to the harm caused by the alleged difference between the senior notes, worth $153 million, and the cash flow certificates, worth $110 million less. 

Second, the bankruptcy court determined that this harm would not have existed "but for" the restructuring transaction, and, thus, the restructuring transaction was the "operative act." 

Finally, the bankruptcy court concluded that the operative act was explicitly encompassed by the inadequate consideration exclusion because the restructuring transaction involved an "actual payment" by the mortgage company of "inadequate consideration"—the cash flow certificates—in connection with the mortgage company’s purchase of "securities issued by any company"—in this case, its own senior notes.  Accordingly, the bankruptcy court determined that the exclusion barred coverage for the underlying complaint in its entirety.  As a result of that determination, the court did not reach the insurers’ other argument that the amount at issue in the underlying case did not constitute "Loss" as defined by the policies.

After concluding that all of the mortgage company’s claims in the adversary proceeding were barred by the inadequate consideration exclusion, the bankruptcy court rejected the mortgage company’s waiver and estoppel arguments, which were based on the passage of 18 months before the primary insurer denied coverage.  The bankruptcy court noted that, under New York law, an insurer could not waive a defense to coverage, and the mortgage company had failed to allege sufficient facts demonstrating its reliance on the failure to issue a coverage position.  Finally, relying on the reasoning in In re Stone & Webster, Inc., 367 B.R. 523 (Bankr. D. Del. 2007), the bankruptcy court agreed with the insurers that the adversary proceeding was a non-core proceeding.

Commentary

In recent years, it has become increasingly common for D&O carriers to issue policies containing "inadequate consideration" exclusions, or as they are sometimes known, "bump up" exclusions. Carriers designed these exclusions to address disputes that sometimes arise in connection with merger objection lawsuits.

These kinds of lawsuits routinely emerge after the announcement of a merger or acquisition. Invariably, plaintiffs’ attorneys file a lawsuit claiming that the acquired company’s shareholders were receiving inadequate consideration for their shares in the acquired company. These lawsuits sometimes end with the defendant acquirer agreeing to pay some additional consideration. The acquirers then sometimes try to pass these increased acquisition costs to the D&O insurers. The carriers object to paying amounts that they contended was merely a transaction cost and did not "loss" as a result of a wrongful act.

In order to try to avoid disputes over these increased consideration, or "bump up," amounts, some carriers have attempted to insert exclusions for "inadequate consideration" claims into their policies. These kinds of provisions are not always included in D&O policies, nor is the wording in the various exclusions used in the marketplace uniform. In addition, there is very little case law interpreting these kinds of provisions.

The Delta Financial decision highlights a number of noteworthy aspects of the particular exclusion language used in the applicable policy that may be important in connection with the wording of these kinds of exclusions.

First, it is important to note that the allegations of inadequate consideration were made in connection with the company’s acquisition of its own securities, rather than those of another company. The court’s ruling certainly underscores the significance of the exclusion’s use of the word "any" in the phrase "the securities issued by any company," as opposed to, for example, the possible alternative use of the word "another." Had the exclusion used the word "another" rather than "any," the outcome could well have been different.

Although it was not relevant in the context of this particular dispute, the exclusion’s reference only to "securities" also highlights the possible outcome determinative impact in other situations if the exclusion were also to refer to "assets of" in addition to the "securities issued by" any company. The exclusion’s reference only to securities, as opposed to both securities as well as assets, is narrower, as a result of which the exclusion would, in this respect at least, have a narrower preclusive effect.

Many readers undoubtedly noted that this case arose out of the bankruptcy of a residential mortgage origination and servicing company that funded its lending operations by selling interests in securitized pools of mortgages, a business pattern that is not unfamiliar these days (nor indeed is the bankruptcy itself unfamiliar these days). The procedural context, and perhaps even the substantive dispute, may presage a host of disputes that may lie ahead in connection with the subprime and credit crisis-related litigation wave.

In any event, the outcome of the coverage dispute underscores a point that I have made many times in the past on this blog—that is, the critical importance of policy wording.

Very special thanks to Dan Standish of the Wiley Rein firm for providing a copy of the Delta Financial opinion and for allowing me to reproduce his firm’s case summary.

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We interrupt our regularly scheduled stream of dispatches from the credit crisis front to provide a quick update on the now seemingly remote options backdating scandal. Even though the whole world has moved on and though options backdating pales by comparison to what followed, many options backdating cases continue to grind on. At least a couple of these cases recently settled, and there appear to be many more yet to come.

First, on December 11, 2008, Amkor Technologies announced (here) that it had reached an agreement to settle the option backdating-related securities class action lawsuit that had been filed against the company and certain of its current and former directors and officers in connection with the company’s historical stock option practices. Background regarding the lawsuit can be found here.

According to the company’s press release, the plaintiffs have agreed to dismiss the case in exchange for a payment of $11.25 million. The company said that its directors and officers liability insurance carrier has agreed to pay $9 million of the settlement amount and the company will pay the balance.

Second, and also on December 11, 2008, the parties to the options backdating-related shareholders’ derivative suit filed against Foundry Networks, as nominal defendant, and certain of its directors and officers, filed a notice of a proposed settlement (here). According to the parties’ filing, the company will receive cash payments of $2.117 million, of which $1.637 represents payments from the individual defendants and $400,000 represents payments from the company’s insurer. Certain shares granted to certain individuals have been repriced and the company also agreed to certain governance changes. The company also agreed to pay plaintiffs’ attorney’s fees and expenses of $1.2 million.

I have added these two settlements to my running table of options backdating-related lawsuit settlements, dismissals and motion denials, which can be accessed here. The Amkor settlement is, by my count, the sixteenth options backdating-related securities lawsuit settlement, and approximately six of the cases were also dismissed. Given that there were according to my count (refer here) 39 options backdating-related securities lawsuits filed in total, there still may be as many as 17 of these cases yet to be resolved.

The individuals’ cash contribution toward the Foundry Networks settlement, if not indemnified, would represent an unexpected element, as it remains an unusual settlement element for directors and officers to make cash settlement contributions out of their own assets.

OK, enough about that. We now resume our regularly scheduled programming, which is already in progress.

California Countrywide Subprime-Related Derivative Case Dismissed: In a December 11, 2008 order (here), Judge Mariana Pfaelzer dismissed the Countrywide subprime-related derivative case pending in the Central District of California.

Judge Pfaelzer previously had denied the defendants’ motion to dismiss the derivative case, in a strongly worded May 2008 opinion (about which refer here). However, in July 2008, Bank of America acquired Countrywide in a stock for stock merger. As a result, and as discussed here, in October 2008, the Delaware federal court dismissed the parallel Countrywide subprime-related derivative case pending in that court, because of the plaintiffs’ lack of standing to pursue the claim owing to the plaintiffs’ inability to show "continuous ownership" due to the BoA transaction.

The plaintiffs in the California Countrywide subprime-related derivative case argued that, notwithstanding the merger, they could still satisfy the "continuous ownership" rule and therefore still had standing based on a merger-related exception to the rule recognized in the Ninth Circuit. After detailed consideration of Erie Doctrine issues, Judge Pfalzer declined to exercise equitable powers associated with the merger-related exception, and granted the defendants’ motions to dismiss the derivative claims due to the plaintiffs’ lack of standing.

Judge Pfaelzer’s ruling on the derivative claims was without effect on the plaintiffs’ merger related class claims, which she previously had stayed in favor of parallel proceedings pending in Delaware Chancery Court. In addition, the Countrywide subprime-related securities class action lawsuit remains pending before Judge Pfaelzer, as a result of her recent dismiss motion denial in that case, discussed here.

In any event, I have added the dismissal of the California Countrywide Derivative lawsuit to my list of subprime lawsuit settlements, dismissals and motions denials, which can be accessed here.

Special thanks to Michael Delhegan of the Tressler Soderstrom firm for providing a copy of Judge Pfalzer’s December 11, 2008 opinion.

Standalone Insurance for Independent Directors: In prior posts (most recently here), I have noted the considerations that may militate in favor of standalone insurance protection for independent directors. In a December 12, 2008 memorandum entitled "Independent Directors Require Additional Protection in Financial Crisis Litigation" (here), the Baker & McKenzie firm suggests that "there is an increasing interest by independent directors in coverage that protects only a company’s independent or outside directors, not its officers."

The memo reviews the origins of IDL insurance and examines why "it may be a useful tool for both attracting high quality independent directors, and as a means of protecting and retaining the best talent." Among other reasons suggesting the need for IDL protection is the increasing susceptibility of traditional D&O insurance limits to erosion or depletion through defense expense or indemnity protection for other persons insured under the D&O policy, a phenomenon on which I previously commented here.

More About the NY Insurance Commissioner’s Recent Opinion: In a recent post (here), I commented on the recent opinion of the New York Insurance Commissioner’s office requiring D&O insurance policies to incorporate a duty to defend. The opinion and its implications are reviewed at greater length in a December 2008 Client Advisory from the Edwards, Angell, Palmer & Dodge law firm entitled "The New York Insurance Department Will No Longer Approve D&O Policies Lacking ‘Duty-to-Defend’Coverage Feature" (here).

This memo contains a detailed analysis of the opinion and raises a number of important considerations about what the opinion does and does not mean. The memo also notes difficulties that carriers may face as the attempt to adapt to the opinion, and also suggests alternative responses available to the carriers, including seeking legislative relief.

Special thanks to John McCarrick of the Edwards Angell firm for sending along a copy of the memo.

And Finally: By far the best thing I have seen written on the Madoff scandal is the column that Wayne State Law Prof. Peter Henning wrote as a guest column on the DealBook blog, here.

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In a deeply troublesome decision, the New York Department of Insurance has issued an October 16, 2008 opinion (here) stating that "a D&O policy may not include a provision that places the duty to defend upon the insured, rather than the insurer." A December 5, 2008 memo (here) written by Carrie Cope, a partner in the Tressler, Soderstrom Maloney & Preiss law firm, diplomatically but accurately summarizes just how far off base the opinion is.

By way of background, public company D&O insurance as it is uniformly distributed and purchased throughout the entire U.S. marketplace today is written on a duty to indemnify rather than a duty to defend basis. Under this arrangement, the insured persons, rather than the insurer, select their defense counsel, subject to the insurer’s consent, and the insured persons control their defense. The insurer reimburses reasonable defense expense.

Not only is this arrangement the uniform marketplace standard for public company D&O insurance, but it is the clear and unambiguous preference of public company D&O insurance buyers, who want to be able to use their own counsel in matters affecting their personal liability.

This arrangement has also has been approved by state court insurance regulators throughout the country. As Cope’s memo succinctly points out, the New York Insurance Department’s opinion is directly contrary to this well established regulatory record.

Cope also notes that the opinion "fails to address the needs and desires of the Insureds that it seeks to protect." She correctly points out that public company D&O insurance policies are purchased by sophisticated parties represented by risk managers and other specialized insurance professionals who seek to procure the best insurance available for their clients. The terms and conditions are highly negotiated. While virtually every word in the policy is subject to intense scrutiny, no one is trying to insert a duty to defend into their public company D&O insurance policy.

The D&O insurance industry’s uniform adoption of a duty to indemnify approach rather than a duty to defend approach is not the result of some insidious insurance company conspiracy. It is instead exactly what sophisticated and well-advised insurance buyers want.

Cope also correctly points out the opinion’s flawed logic. The opinion seeks to criticize the specific insurance policy addressed in the opinion because it transfers to the insured the burdens of litigation "such as managing, controlling or otherwise overseeing the litigation." As Cope notes, the opinion "fails to recognize that the ability to oversee the litigation is exactly what the typical insured purchasing a public company D&O policy wants." (Emphasis added).

The opinion also criticizes the policy because it does not pay the compensation costs of in-house counsel. Cope correctly notes that even if the policy were a duty to defend policy, it would not cover these costs.

Cope concludes her memo by noting that the opinion, "if not further modified, may well have a chilling effect upon the D&O insurance industry in New York and unduly cause applicants to seek means to obtain coverage they need and want outside the State of New York."

Cope is correct. This opinion is not in anyone’s interests, and in particular it absolutely is not in the interests of any person to be insured under a public company D&O insurance policy. Cope’s memo should be a rallying cry for all industry participants to have this erroneous opinion modified or set aside as soon as possible.

Special thanks to the several readers who sent me copies of Cope’s memo.

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A recent appellate court opinion interpreting a D&O liability insurance policy securities exclusion carries some important reminders both about policy wording precision and about exclusionary language, and also raises some critical questions about the scope of coverage for securities claims generally.

In an October 27, 2008 opinion (here), the Eighth Circuit, applying Minnesota law, held in the In re SRC Holding Corp. case that there is no coverage under a D&O liability insurance policy containing a securities claims exclusion for claims made against a financial services company and certain of its directors and officer for alleged wrongful acts in connection with the company’s underwriting and sale of certain municipal bonds.

Following a description below of the case’s background and the appellate court’s holding, I discuss the implications of the Eighth Circuit’s decision.

Background

Between 1996 and 1999, Miller & Schroeder (M&S), a securities underwriter and broker, underwrote and sold $140 million of municipal bonds. The bonds later defaulted and the bond investors initiated lawsuits and arbitration proceedings against M&S and certain of its directors and officers, alleging breaches of federal securities laws and other violations. M&S ultimately went into bankruptcy.

M&S’s D&O insurance carrier denied coverage for the claims. The bankruptcy trustee initiated a lawsuit against the D&O insurer alleging breach of contract and seeking a judicial declaration of coverage. The individual M&S directors and officers intervened in the trustee’s action.

The bankruptcy court held that the policy exclusion on which the insurer relied to deny coverage did not preclude coverage for all of the claims and that the carrier must defend the individuals against all claims. The district court affirmed the bankruptcy court’s ruling and the carrier appealed.

The Eighth Circuit’s Decision

On appeal, the carrier argued that the district court erred in finding that the policy required the carrier to provide the directors and officers with defense cost coverage and indemnification for the bond investors’ claims.

The carrier relied on Endorsement No. 3 to the policy, which provides that:

In consideration of the premium charged, this Policy does not apply to any Claim based on, arising out of, directly or indirectly resulting from, in consequence of, or in any way involving any actual or alleged violation of:

(1) the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, any other federal law, rule or regulation with respect to the regulation of securities, any rules or regulations of the United States Securities and Exchange Commission, or any amendment of such laws, rules or regulations; or

(2) any state securities or "Blue Sky" laws or rules or regulations or any amendment of such laws, rules or regulations; or

(3) any provision of the common law imposing liability in connection with the offer, sale or purchase of securities.

The district court held that this exclusion precluded coverage only for M&S’s sale of its own securities, but not otherwise. In reaching this conclusion, the district court relied in part on the testimony of the insurance broker who sold the policy, who testified, according to the appeals court, that "this standard-form securities exclusion is typically intended to exclude coverage for liability resulting from the insured’s sale of its own stock."

As the appeals court paraphrased the district court’s logic, because the provision had a "typical effect," the meaning of the provision "must accord with that typical effect." The district court said that this was the only interpretation that "makes sense."

The appeals court held, however, that the district court erred in relying the broker’s testimony. Because the district court held (correctly in the appellate court’s view) that the provision is unambiguous, it was erroneous as a matter of Minnesota law for the court to rely on extrinsic evidence in interpreting the provision.

The Eighth Circuit said that "the effect of [the securities exclusion] as it may be generally applied in practice is not the legal authority that governs our coverage inquiry here; it is the mutually agreed-upon policy’s plain language that binds [the parties] in the first instance." The appeals court noted that

Sophisticated business entities who rely on experts to advise them are best suited to determine what makes the most economic sense and the language they have mutually negotiated and agree to is the best evidence of what those parties intended.

The appeals court held that the endorsement is "not limited to claims arising out of M&S’s sale of its own securities," as such a limitation "is nowhere to be found in its language."

The appeals court also rejected the suggestion that this interpretation was inconsistent with other provisions in the policy.

The insureds argued further that in any event coverage for claims against them for alleged violations of NASD rules were not precluded, and therefore that the carrier was obliged to fund the defense, even as to non-NASD proceedings.

The appeals court rejected this argument as well, in reliance on the Endorsement No. 3’s broad preamble ("based upon, arising out of, directly or indirectly resulting from, in consequence of, or in any way involving…"), as well as the policy’s provisions broadly treating interrelated matters as a single claim.

Because the alleged NASD violations "arise out of, flow from and have their origins in the same set of operative facts" as the claims alleging violations of the securities laws, for which coverage is broadly excluded under the policy, they fall "well within the ‘arising out of’ exclusionary language of Endorsement No. 3."

The Wiley Rein law firm, which represented the carrier before the appellate court, has a detailed memorandum here summarizing the Eighth Circuit’s decision is greater detail.

Discussion

The Eighth Circuit’s ruling is noteworthy in and of itself, as a federal appellate court decision vigorously holding that insurance policies negotiated between sophisticated parties must be interpreted strictly according to their terms.

The opinion also represents a cautionary tale for practitioners in this area, and it is well worth considering more fully in that light.

None of my remarks are meant in any way as a criticism of the broker involved. Clearly, the broker’s view of how this policy should operate had a substantial basis, as both the bankruptcy court and the district court adopted the broker’s interpretation.

However, the Eighth Circuit’s opinion is a harsh reminder that, notwithstanding what the common understanding may be about the meaning or operation of policy provisions, ultimately courts will look at a policy‘s actual language. As the Eighth Circuit’s opinion demonstrates, a court’s policy interpretation may or may not coincide with common understandings or expectations. For practitioners in this area, the appellate court’s ruling underscores that what matters is wording not intent.

In addition, the court’s reliance on the breadth of Endorsement No.3’s exclusionary preamble is a reminder of the inclusive nature of this type of omnibus language. The Eighth Circuit found that the use of this broad preamble substantially extended the reach of the provision’s exclusionary effect, which represents its own reminder to practitioners of the critical importance of the way in which policy provisions are framed, particularly policy exclusions.

A critical part of the coverage dispute here relates to the fact that the securities violations alleged arose not in connection transactions involving the insured company’s own securities. This aspect of the dispute raises a more general question about how, in the absence of a securities claim exclusion, D&O insurance policies should respond to claims of securities law violations asserted by persons other than the insured company’s own shareholders.

There have been some high profile 2008 examples of securities lawsuits filed by persons other than the defendant company’s own shareholders. The numerous auction rate securities claims represent one example. Another example is the securities class action lawsuits filed against, among others, Hexion Specialty Chemical and certain of its directors and officers by shareholders of Huntsman Corporation. The Huntsman shareholders alleged that the Hexion defendants "deceived the investing public regarding Hexion’s efforts and intentions with respect to the merger with Huntsman." (Refer here for further background about the Hexion claim).

These recent examples, as well as the M&S case discussed above, underscore the possibility of securities allegations by persons other than a company’s own shareholders. These kinds of claims can arise not only in connection with financial companies, like M&S and the companies involved in the auction rate securities cases, but can also involve non-financial companies, like Hexion.

Questions of policy coverage for these types of securities lawsuits potentially could be significant not only in connection with the type of exclusionary language in the M&S case, but also in connection with the definition of "securities claim" found in the typical D&O insurance policy.

There are standard formulations for the definition of the term "securities claim." One formulation is oriented toward claims arising under the securities laws and the other is oriented toward claims involving the issuer’s securities or the issuer’s securities holders.

Definitions of the term "securities claim" oriented toward the securities laws themselves will extend more broadly without respect to who has asserted a claim and are more likely to encompass securities lawsuits filed by persons other than a company’s own shareholders.

Definitions of the term "securities claim" tied to claims involving the company’s own securities, rather than more broadly to claims involving the securities laws generally, could be interpreted more narrowly with respect to securities lawsuits brought by persons other than the company’s own shareholders.

All of which begs the question: how should the policies respond to securities lawsuits against insured persons filed by claimants other than the company’s own shareholders? In my view, because these claims allege wrongful acts by persons insured under the policies, they represent precisely the kind of litigation for which the policy should provide coverage. Of course, whether any particular policy will respond to this kind of claim depends on the actual policy language.

Financial Collapse: The Board Game: According to a November 28, 2008 Financial Times article entitled "Icelanders Collapse in Laughter" (here), some Icelanders, tapping into their typically "darkly ironic sense of humor" have developed a board game "that takes a grimly comical swipe at the financial crisis that has devastated the economy."

Players roll dice and move around the game board while drawing cards that, for example, allow them to buy a private jet or obtain a foreign loan, or perhaps go bust. Icelanders have been suggesting additional content for the cards via the Internet. Among other cards suggested is one reading "Go to demonstrate at parliament, stop to buy some eggs to throw, only to realize that prices have gone up so much you can’t afford them."

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This past week, in conjunction with the PLUS International Conference in San Francisco, the insurance information firm Advisen issued an updated forecast of insurance losses likely to arise from the credit crisis. As reflected in its November 5, 2008 press release (here), Advisen is now estimating aggregate D&O and E&O losses of $9.6 billion, up from the firm’s February 2008 $3.6 billion forecast. The firm also issued separate reports detailing its analysis of D&O losses (refer to report here) and E&O losses (report here).

Advisen has not only increased its estimate since February, it has widened the scope of what it is estimating. Thus, for example, the earlier estimate referred only to projected losses from securities class action lawsuits. The most recent estimate includes anticipated losses from derivative lawsuits, governmental investigations and other matters. The more recent forecast includes other items not incorporated into the prior estimate, such as an estimate for defense fees incurred on dismissed claims. For these and other reasons, some caution is advised in comparing the two estimates, as the overall increase in part reflects differences in the estimation process.

In addition, Advisen’s aggregate $9.6 billion forecast falls within a broader range of estimated combined D&O and E&O losses of from $6.8 billion to $12.1 billion. The sheer breadth of this range (reflecting a potential swing of as much as $5.3 billion) underscores the continuing difficulty of attempting to quantify the insurance industry’s potential credit crisis-related losses.

There are several considerations that make any current attempt to quantify the insurance industry’s credit crisis related exposure particularly challenging.

1. What are We Measuring?: Both the credit crisis and the associated litigation have expanded and evolved since the started to emerge in early 2007. Moreover, as a result of the dramatic events that shook the global financial markets in September and October 2008, what began as a subprime meltdown has now become a more generalized downturn affecting the broader economy. As I have emphasized in recent posts (refer here and here), the broader economic turmoil has produced its own associated litigation, and further litigation seems highly likely.

Because of these recent developments, it has become increasingly difficult to define with precision what is and what is not "credit crisis-related." The lines defining the category have blurred to the point that it may be difficult to say with any certainty what is being measured. The absence of definitional clarity makes both descriptions and predictions particularly precarious. The very attempt to quantify credit crisis related losses implies a categorical precision that may no longer exist.

2. Measurement Distortions: Most attempts to describe the credit crisis exposure reference the total number of securities lawsuits. While this total is important, the reality is that the number of lawsuits is greater than the number of companies sued. Several companies have been sued multiple times on behalf of different sets of putative claimants, as the Advisen report duly notes. To the extent the successive lawsuits hit the same insurance program, they are less likely to increase the insurance industry’s overall losses.

Moreover, as I discussed here, early returns suggest that the courts have proved skeptical that investor losses in the context of a marketwide meltdown are the result of fraud. It is far too early to generalize from these early returns, but to the extent the courts remain skeptical, the overall potential impact of this litigation could be diminished.

In addition, the insurance losses on any particular claim will vary widely depending not only based upon the issues affecting the underlying liability exposure, but also affecting the extent of insurance coverage triggered. Issues such as retentions, program structure, limits availability, as well as overall terms and conditions, could significantly affect the extent to which the payment of insurance proceeds is triggered in any particular claim.

As the Advisen report notes, these issues are particularly relevant for claims against companies in the financial sector, as many of these companies carry very large self-insured retentions or have limited their insurance coverage protection solely to Side-A only protection. These coverage-related issues could substantially determine the extent of insured losses in many claims, which in turn could substantially affect the insurance industry’s aggregate exposure.

3. The Uncertainty of Events to Come: Any estimate of the insurance industry’s overall credit crisis-related exposure necessarily encompasses not only projections about the lawsuits that have already been filed, but also incorporates assumptions about the number and seriousness of lawsuits yet to be filed. In addition, the estimate also includes certain assumptions about how much longer the new lawsuits will continue to emerge.

Advisen suggests that the losses will spread into 2009, reflecting an apparent presumption that the accumulation of lawsuits will run only through 2009. My crystal ball is no better than any one else’s, but my own view is that lawsuits associated with the current economic crisis will continue to emerge for some time to come, and more specifically will continue well beyond the end of 2009. But the critical issues here is that any attempt to estimate the insurance losses entails certain assumptions about the lawsuits yet to come, and the magnitude of the losses estimated will vary materially depending on the assumptions used.

The foregoing analysis suggests a number of competing considerations, some of which might imply larger overall insurance losses, some of which cut the other way, and some of which that will have an uncertain impact. For that reason, I think it is particularly difficult to try to estimate the insurance industry’s overall exposure from the credit crisis related litigation. As a result, I have no opinion one way or the other about the accuracy of Advisen’s estimate.

That said, I agree with Advisen that the insurance industry’s overall losses are going to be very large, and that whatever the loss projection might have been in February 2008, developments since that time suggest that the number almost certainly has increased. Moreover, as a result of the events in the financial marketplace during September and October 2008, there are increased prospects for further significant losses to continue to accumulate across a wide variety of companies and across a wide variety of industries. There is every possibility that Advisen will find it necessary to increase its estimate in the future.

I think the most recent developments in the financial markets may be particularly significant for the insurance industry’s ultimate losses. These events included some enormously significant events, including, for example, the largest bank failure in U.S. history, the bankruptcy of one of the largest investment banks, and the government’s bailout of the largest insurance company. At the same time, commodity prices and currency exchange rates changed direction abruptly and significantly. These and other developments will continue to reverberate through the global economy for months and perhaps years.

One of the direct consequences from these developments is that there will be significant additional litigation, and this additional litigation will emerge for some time – as I noted above, the litigation could well continue to emerge beyond the end of 2009. Because of the turmoil in the global financial market, this litigation is widely dispersed across the entire economy. That is, unlike the litigation exposure that prevailed in the early stages of the subprime meltdown and credit crisis, which was concentrated in the financial and real estate sectors, the litigation exposure now ranges across most industries and many companies.

Is the D&O Insurance Industry Headed for a Hard Market?: The insurance industry in general has not yet reacted fully to these developments. To be sure, and as fully noted in the Advisen report, companies in the financial sector are now seeing D&O insurance price increases and a more challenging underwriting environment. The Advisen report also suggests, correctly in my view, that there are a variety of factors that potentially could lead to a hardening market ahead, including in particular the losses associated with Hurricane Ike and other catastrophic events, as well as the marketplace disruptions involving AIG and the investment losses that have accumulated at other leading carriers.

All of that said, other than with respect to companies in the financial sector, there is little present evidence of a market turn. For most companies, conditions remain competitive, and both pricing and available terms and conditions remain attractive.

A harder market may well lie ahead, as Advisen suggests. The question is how far ahead. I doubt companies generally will experience a hard D&O insurance market until insurers are reporting substantial calendar year losses across their D&O portfolio.

The Advisen report suggests that the credit crisis-related losses will be spread "across 2007, 2008 and 2009." However a close reading of the Advisen reports reveals that Advisen is referencing "accident years" not "calendar years." Losses associated with claims in a particular accident year may not be fully developed until years later. An insurer recognizes a loss only when the claim is paid or a reserve against the ultimate amount is finally established. The calendar year in which the loss is finally recognized may be years after the accident year in which the claim first arose. The lag time to the ultimate loss in the professional liability insurance lines can be as long as three years or more. The lag time creates a risk (all too often realized) of loss underreporting.

Another danger of the lag time is the possibility that carriers may misunderstand their own loss experience, which could produce a mismatch between the risks assumed and the pricing charged. Exacerbating this concern is the insurers’ delayed recognition that the litigation threat from the evolving credit crisis has spread to the larger economy. Simply put, current pricing may not reflect the existing litigation exposure.

The interaction of these factors suggests the possibility that the arrival of the harder market could be delayed but could be even more disruptive when it arrives. The carriers that are the slowest to recognize the changed circumstances will be the ones that experience the most disruptive impact.

Of course, to the extent that AIG’s travails and other carrier’s investment portfolio woes produce a shortage of insurance capacity, the hard market’s arrival could be accelerated. But my own view is that predictions of a hard market for D&O insurance could be premature until the insurers begin to recognize serious calendar year losses in the professional liability lines.

More Bank Closures: In what has become a regular Friday night ritual, after the close of business on Friday November 7, 2008, the FDIC announced the closure of two more banks.

First, the FDIC announced (here) that state regulators had seized and the FDIC had been appointed the receiver of Franklin Bank of Houston Texas. Second, the FDIC also announced (here) that it had been appointed receiver of Security Pacific Bank of Los Angeles, California, after the bank was closed by state banking authorities.

These two bank closures represent respectively the eighteenth and nineteenth bank closures so far during 2008. The FDIC’s complete list of bank closures during the period October 1, 2000 through the present can be found here. Of the 19 bank closures year to date, thirteen have occurred since July 1, 2008. Moreover, after the close of business for the past four Fridays in a row, the FDIC has announced at least one bank closure.

The year to date number of bank closures already represents that highest annual total since 1993, at the tail end of the last era of failed banks. More to the point, the pace of bank closures, which has increased in the second half of 2008, has accelerated over the past four weeks.

For anyone who remembers the last era of failed banks, these bank closures represent a particularly ominous sign. They also represent one more reason why I believe that the turmoil from the credit crisis, and associated litigation, will continue for some time to come.

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

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

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

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One of the most closely followed recent case developments in the D&O insurance arena is the ruling in the CNL Hotels & Resorts case that a Section 11 settlement did not represent covered loss under a D&O insurance policy. As I noted in a recent post (here), on August 18, 2008, the CNL Hotels & Resorts holding was affirmed by the Eleventh Circuit. These developments have occasioned a great deal of discussion and commentary in the D&O insurance community.

Among the more noteworthy commentary on this topic is the analysis of the well-known and widely respected D&O insurance coverage attorney, Joe Monteleone of the Tressler, Soderstrom, Maloney & Preiss law firm. Joe’s commentary appeared in his firm’s August 2008 Specialty Lines Advisory (here, at page 2). As always, I found Joe’s analysis interesting, but I also found that I disagreed with him on a portion of his analysis.

Because I thought an exchange of views on these topics would be useful and perhaps even entertaining, I approached Joe to determine his willingness to engage in a colloquy on this topic to be reproduced on this site. Joe agreed, and our exchange follows below. First, I have quoted a portion of Joe’s article, which is followed by my comments on his article. Joe’s rebuttal appears after my comments.

Joe's Article (Extract):

In his commentary, Joe wrote the following with respect to the CNL Hotels & Resorts case (and cases with similar holdings): 

When you cover the entity for its Section 11 loss, you are in effect saying that your IPO was overpriced by perhaps tens of millions of dollars. While not saying that it is OK, what you are saying is we will let the insurer step in and pay that loss and the corporation can keep its ill-gotten gain. How is that any different than a company simply refusing to pay for goods it has ordered and then letting its insurer pay when it is sued for a breach of its contract to pay? Insurance may cover negligent and even reckless misconduct, but it should not cover crooked behavior.

  Kevin's Comments:

In his article, Joe makes a number of valid and interesting points, particularly with respect to the history of these issues. However, underlying Joe’s legal analysis is a series of value judgments. It seems to me that these value judgments misapprehend several critical considerations. I have set out these critical considerations below. In doing so, I also recognize that courts may have disfavored several of my arguments; readers will judge for themselves whether it is legitimate for me to reference these judicially disfavored points here

The first important consideration is that while companies that are the target of Section 11 claims may be alleged to have made all sorts of misrepresentations or omissions, these allegations are virtually never put to the test of proof. The mere fact that plaintiffs allege that offering documents contained supposed misrepresentations does not mean that the offering proceeds were in fact "ill-gotten." These kinds of claims, like all claims, are compromised because of the burdens and expense of litigation and because few are willing to accept the risk of an adverse verdict.

Nor does the fact that substantial sums are paid to compromise these claims, in and of itself, mean that the defendants company’s IPO was overpriced, much less that the company engaged in "crooked behavior." These settlements take place after the company has experienced a significant stock price drop. Compromising claims in the context of significant market capitalization losses can prove costly, but entry into even a costly settlement is far different than a determination of culpability or wrongdoing.

But I have even deeper concerns beyond just the fact that a settlement does not in and of itself betoken that a company’s IPO was "overpriced" or that the company is improperly keeping "ill-gotten gains." The fact is that the use of heavily freighted words such as "ill-gotten" and "crooked" are fundamentally misplaced in connection with alleged corporate liability in a Section 11 claim.

Under well-established legal principles, corporations are said to be "strictly liable" under Section 11 for material misrepresentations and omissions in offering documents. There is no element of fraud or scienter required in a Section 11 claim, and indeed plaintiffs pleading claims under Section 11 now routinely state (as a means of averting onerous pleading requirements) that they are not alleging or averring fraud in relation to these claims. The point is that in general not even the plaintiffs asserting the claims against these companies allege that the companies engaged in "crooked behavior."

In his article, Joe concedes that insurance properly can be paid for behavior that is merely negligent or even for behavior that is reckless. How then is it appropriate to withhold insurance benefits from companies who can be found liable without any fault at all?
 

I know that the district court in the CNL Hotels & Resorts case said that the absence of fraud allegations in Section 11 claims represents "distinction without a difference." But the absence of allegations of knowing or reckless misconduct does matter, deeply. The use of acutely pejorative words – that are completely unwarranted given the strict liability standard for corporate liability under Section 11 -- has the effect of demonizing the company and putting it the position of moral error. The danger is that it is easier to withhold insurance benefits from a "bad" company. The use of these morally freighted words not only inappropriately shapes the tone of the dialog but potentially enables an unjustified result.

Moreover, even if a Section 11 claimant should allege fraud or dishonesty, the typical D&O policy’s fraud exclusion ensures that insurers do not have to pay benefits for "crooked behavior." But here’s the thing about the fraud exclusion – at least as worded in most current policies, it is only triggered after an adjudication of fraud. The fraud exclusion is no barrier to the payment of insurance benefits to fund settlements of claims alleging fraud.

Indeed, insurance companies regularly fund Section 10(b) claim settlements, notwithstanding allegations of fraudulent misconduct. Surely Joe is not suggesting that insurers cannot properly fund Section 10(b) settlements? And if Section 10(b) settlements properly can be funded because there has been no adjudication of fraud, why can insurers withhold payment of insurance benefits from Section 11 benefits in the absence of an adjudication of fraud, merely because of unproven allegations of "ill-gotten gains" or even "crooked behavior"?

An August 25, 2008 New York Law Journal article by Joshua Sohn of the DLA Piper law firm entitled "Liable Until Proven Innocent" (here) decries the leniency of Section 11 and Section 12(a)(2) pleading requirements. Among other things, Sohn quotes the Supreme Court’s recent Twombley opinion to assert that lenient Section 11 and 12(a)(2) pleading standards will continue to "push cost-conscious defendants to settle even anemic cases."

The lenient pleading standards make IPO companies that experience sharp stock price drops likely targets for Section 11 claims. The leniency of the Section 11 liability standards also means that the lawsuits are likely to survive preliminary motions, leaving defendant companies few options other than settling. Because of this heightened susceptibility to dangerous litigation, companies about to conduct an IPO are particularly sensitive to the need for D&O insurance.

An IPO company is generally regarded as an attractive insurance prospect, and many insurers compete actively to write the insurance for IPO companies. The confounding thing is that insurers that actively competed for the business and voluntarily undertook to insure an IPO company would later contend that the most likely and most dangerous claim the company would face is uninsurable. Whether or not this coverage position makes the insurance agreement illusory, it certainly raises serious concerns about the utility of the insurance agreement.

It will be argued that public policy prohibits insurance for corporate Section 11 liability because the relief sought is restitutionary in nature. As a general matter, the determination of private contractual matters based on public policy grounds raises certain fundamental question about the sources and uses of law. One particular concern is that the supposed requirements of public policy lack a definite point of reference and could become simply a matter of perspective. The notion than insurance for Section 11 claims is against public policy is neither inherent nor absolute, and indeed is an issue on which pertinent parties take a point of view different than followed in recent case law.

The SEC’s perspective is particularly relevant to this public policy question. On the one hand, the SEC takes the position (here) that corporate indemnification for ’33 Act liabilities is "against public policy" and unenforceable. On the other hand, the SEC emphatically does not specify that insurance for ’33 Act liabilities is against public policy. To the contrary, the SEC expressly designates (here) as among the expenses that properly may be charged to the costs of a securities offering the premium charged for insurance "which insures or indemnifies directors or officers against any liability they may incur in connection with the registration, offering or sale of such securities."

The SEC’s public policy analysis distinguishes between the indemnification of Section 11 liability and the provision of insurance for Section 11 liabilities. The SEC’s statements suggest that in its view public policy does not prohibit the enforcement of policies insuring against Section 11 liability, by contrast to its indemnification.

If nothing else, the SEC’s views ought to suggest that what public policy dictates as far the insurability of Section 11 claims is neither self-evident nor universally held. All of which should raise serious concerns about using judicially declared principles of supposed public policy to determine private contractual rights.

It was a nearly universal reaction among both D&O underwriters and brokers that this line of case law produced a result that, while perhaps perfectly logical to an insurance lawyer, ran absolutely contrary to marketplace understanding and commercial expectations. It is worth considering that both underwriters (the ones who sell insurance) and brokers (the ones who procure insurance on behalf of insurance buyers) universally agree that D&O policies should cover these kinds of settlements.

In response to these concerns, the entire D&O insurance industry has taken steps, as quickly and as vigorously as any insurance-related industry has ever done anything, to try to insert policy language calculated to prevent lawyers from making arguments that while perhaps logical to the lawyers defy the expectations and understandings of the commercial marketplace. The marketplace understands that the compromise of disputed Section 11 claims in no way means that a company has engaged in "crooked behavior" and in fact represents the very contingency for which policyholders buy insurance.

Joe's Counterpoints:

Kevin’s repeated admonishments for my use of the term "crooked behavior" call to mind Judge Posner’s words in the Level 3 decision, a case that perhaps more than any other establishes the public policy rationale relied upon by the CNL Resorts courts.

Taking a cue from Judge Posner, I should have refrained from use of the pejorative term "crooked", and I regret any possible inadvertently implied mischaracterization of the motive of the corporate issuer in CNL Resorts or other cases.

Nonetheless, I will now "politely" set forth a number of rebuttal points.

First, I believe the fact that the underlying CNL Resorts litigation, like many other similar litigations, concluded with a settlement and, hence, no evidentiary proof of ill-gotten gain, misses the point of these insurance coverage cases. Regardless of the culpability of the conduct, there could be no liability of the issuer unless the offering was in fact overpriced. To have an insurer pay the amount of the overpricing, rather than have the issuer disgorge it uninsured, results in an unentitled windfall to the issuer.

That being said, I share Kevin’s observation of the irony that in these cases of what is in essence strict liability there can be no insurance recovery, but yet insurers routinely pay to cover liabilities resulting from reckless conduct in other securities cases. Ironic, yes, but it is supportive of the point that culpability of conduct is not the issue.

Also, I would agree that in most of these cases that are disposed via settlement, the insurer cannot apply one or both of its "conduct exclusions", which with increasing frequency in today’s insurance market are written with requirements of a final adjudication in the underlying proceeding. That may hold true for both the dishonesty exclusion and that for personal profit. The latter would arguably apply to preclude coverage for these settlements, but for an adjudication requirement, and in addition to the uninsurability reasoning of the courts in applying the law and public policy.

By no means do these decisions render the insurance agreement illusory, because none of them have applied the uninsurability argument to the individual directors and officers defendants. Thus, in most cases, an allocation should result, but certainly not a complete absence of coverage for all defendants. Although the court in the SR International decision enunciated a public policy argument of having the insurers stand behind the way they market their policies, that was in the context of a dispute over coverage for an underwriter defendant. There is little argument that an underwriter does not receive the proceeds of the offering, and thus its settlement payment cannot be fairly characterized as a disgorgement of ill-gotten gain. Nevertheless, the public policy arguments in that decision give a degree of validity and support to those D&O insurers who have voluntarily attempted to underwrite around the issue by endorsement, notwithstanding what may be the law now in some jurisdictions.

I do not want to belabor the seeming contrast between the SEC’s views on indemnification vs. insurance, but I believe the SEC may well not be inclined to enforce an indemnification prohibition in a settlement context where arguably no Section 11 "liability" has been established.

Finally, I must raise a bit of skepticism at Kevin’s conclusion that insurance underwriters and brokers are in universal accord as to providing "full" coverage for a Section 11 settlement, and that the debate remains only an arcane one among the wonks in the insurance coverage bar. I cannot speak for any particular insurer on this, but it appears at least some were vigorously contesting this issue before the Eleventh Circuit until its decision last month in CNL Resorts. Yes, the endorsements and new policy language purporting to clarify and grant the coverage are frequently seen in today’s market (and, in full disclosure, I have even crafted some of the endorsements and policy language at the request of clients), but I remain reluctant to concede the approach is universal.

Afterword: Consistent with the rules of engagement that I established for this colloquy, Joe gets the last word, so I will offer no surrebuttal. I would like to thank Joe for his willingness to engage on this topic and to offer his views. I would also like to invite readers to chime in on the debate using the blog’s comment feature. (Please note that you can add a comment without providing identifying information, so it possible to add comments anonymously.)

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Because of trees felled last night as Ike’s remnants swept through Ohio, I was unable to make it to the office today. I spent more or less the entire day on the telephone talking about AIG, looking out at my yard strewn with fallen tree limbs, branches, twigs and leaves – a visually suitable tableau give the winds that ripped through Wall Street over the last 48 hours.

With respect to AIG, can I just say that today’s mainstream media coverage regarding AIG was absolutely terrible? For most of the day, various news reports seemed to suggest that New York insurance regulators had authorized AIG’s insurance subsidiaries to loan the parent company $20 billion. However, when the transcript of New York Governor David Paterson’s Monday afternoon press conference (here) was later made available on the Governor’s website, it became clear that what the regulators had authorized was quite a bit different than depicted in the media.

As the transcript explains (if you read the whole thing), the regulators have authorized an "asset swap." The idea is that the insurance subsidiaries are swapping the more liquid assets they hold for less liquid assets of equal or greater value held by the parent company, so that the parent company can post the liquid assets as collateral. The transaction is further explained in a CFO.com article here.

The governor himself noted that this swap transaction alone is not sufficient to see AIG through this current crisis, as the working number for AIG’s current requirements is $40 billion. Much about the asset swap transaction "depends" – that is, it depends on the company’s ability to raise the additional funds it requires, it depends on the actual assets that are transferred, it depends on what further capital requirements AIG may have in this rapidly changing environment.

The critical question of the sufficiency of policyholder protection in light of the asset swap will depend on the quality of the assets exchanged. One can hope that given what is at stake that there is a great deal of transparency concerning the assets the insurance subsidiaries receive. Given the regulators’ involvement, one can also hope that policyholders’ interests will not be subordinated to the interests of AIG’s shareholders or bondholders.

In the final analysis, AIG’s ultimate circumstances may finally depend on what the credit rating agencies do. CNN is reporting tonight (here) that Fitch’s has already downgraded AIG’s financial ratings, which potentially could trigger significant additional collateral requirements on the AIG’s credit default swap contracts, perhaps as much as $13.3 billion. The specifics regarding the Fitch downgrades can be found here. Following suit, S&P has also downgraded AIG's counterparty and financial strength ratings (refer here), with the lowered ratings remaining on credit watch "with negative implications." Apparently the downgrades fully considered the potential benefits to AIG as a result of the asset swap transaction.

Perhaps of equally significant (if not greater) concern to readers of this blog is the action this evening by A.M. Best’s to downgrade AIG’s property/casualty insurance financial strength rating to A (Excellent) from A+ (Superior), about which refer here.

UPDATE: A September 16, 2008 Financial Times article entitled "Downgrades Deepen AIG Woes" can be found here. Moody's has apparently downgraded AIG as well (refer here).

There will be further material developments ahead. The ultimate outcome remains to be seen. The company itself did not publicly comment as these events unfolded today, but some reports suggest that there will be a company statement prior to the opening of the markets tomorrow.

About Lehman: At the same time as AIG’s struggles, the details of Lehman’s demise have started to emerge, starting with the company’s Monday morning bankruptcy petition, which can be found here. The Dealbreaker blog has distilled some of the more interesting tidbits from the petition, here.

A more scholarly look at the Lehman petition can be found on the Bankruptcy Litigation Blog (here), which notes that the petition bears the indicia of having been prepared in haste. The blog also notes that as a result of recent bankruptcy law revisions, Lehman’s petition may face some rather complicated challenges. (Hat tip to Francis Pileggi of the Delaware Corporate and Commercial Litigation Blog, here, for the link to the Bankruptcy Litigation Blog.)

Roger Parloff also discusses on the Legal Pad blog (here) the challenges that Lehman’s petition presents. As statements Parloff quotes on his blog make clear, Lehman may not be able to enjoy one of the primary benefits usually available to company’s filing a bankruptcy petition, the automatic stay. Bankruptcy laws relating exclusively to investment banks provide that Lehman’s transaction counterparties can now, even after the petition filing, seek to terminate their contracts with Lehman, which could further exacerbate the current distress.

And on another note, CFO.com has an interesting article (here) asking the question whether Lehman’s creditors can try to recoup the $5.7 billion in bonuses that Lehman paid its employees in December 2007.

The damage from Lehman’s collapse will be widespread, as investors holding its shares and even its debt securities will likely see little or nothing on their investment. This asset wipeout comes on the heels of the Fannie Mae and Freddie Mac takeout, and at the same time as the precipitous decline in AIG’s shares. All of this means that in a few short days a significant chunk of asset valuation has disappeared (and that is not even counting the overall decline in market values today). These investment losses are going to hit a lot of other companies, not to mention pensions, mutual funds, hedge funds, other insurance companies, endowment funds and so on. These losses will have to be reckoned in the weeks and months to come.

The extent of the consequences from these events may be difficult to foresee even now,  though the events have been widely reported. Who could have foreseen that when Ike came roaring ashore early Saturday morning in Galveston that on Monday morning trees would be down all over Northeast Ohio?

For Those Who Can’t Wait: If you are (like me) one of those people who need to know what it all means, you will want to refer to Professor Davidoff’s overview on the Dealbook blog (here). An analysis that takes a darker, more cynical view of these events can be found on The Big Picture blog (here).

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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A recurring D&O insurance coverage concern involves the question whether the standard pollution exclusion typically found in most D&O policies could preclude coverage for a securities lawsuit alleging pollution-related misrepresentations or omissions. An August 15, 2008 opinion (here) by a New Jersey intermediate appellate court addressed this issue squarely.

The New Jersey Superior Court Appellate Division per curiam opinion affirmed a trial court determination, in a coverage case arising out of a securities class action lawsuit alleging misrepresentation of contingent asbestos liabilities, that the "alleged pollution at issue was too attenuated from the damages arising from the alleged misrepresentations to trigger the pollution exclusion."

Background

The underlying case arose out of a series of complex corporate recapitalization, reorganization and merger transactions, as result of which Sealed Air Corporation acquired certain assets and liabilities previously held by W.R. Grace. In post-transaction statements, Sealed Air made representations concerning its contingent liability for asbestos-related claims retained by a spun-off subsidiary.

As a result of asbestos liability lawsuits against the spun-off subsidiary, the subsidiary sought bankruptcy protection. The bankruptcy court later determined that the corporate reorganization transaction represented a fraudulent conveyance. After the fraudulent conveyance ruling became public, Sealed Air’s stock price plunged.

Sealed Air shareholders initiated a securities class action lawsuit against the company and its directors and officers. Background regarding the securities lawsuit can be found here. The company sought coverage for its litigation costs from its D&O insurer. The D&O insurer denied coverage in reliance upon the pollution exclusion in its policy. The pollution exclusion precludes coverage, in pertinent part, for loss "based on, arising out of, or in any way involving: (a) the actual or threatened discharge, release, escape, seepage, migration or disposal of Pollutants."

Sealed Air filed a declaratory judgment action against the insurer. Following a trial in the coverage action, the trial court entered judgment in the company’s favor, requiring the insurer to advance the company’s securities litigation defense expense. The insurer appealed.

The Appellate Ruling

On appeal, the insurer argued that the exclusion should be "given a literal reading," contending that "the language and effect of the Policy’s pollution exclusion is clear and unambiguous." Sealed Air, for its part, argued that "the alleged loss to shareholders arises out of the allegedly misleading financial statements, not from air-borne pollutants." The company contended that because "the alleged damages arise from securities misrepresentation and not traditional environmental pollution," the policy provides coverage.

The New Jersey Superior Court Appellate Division found that "the language of the policy at issue precludes [the insurer] from disclaiming based on the pollution exclusion." The court said that "it is clear to us that the gravamen of the securities holders’ complaint has its root in securities fraud and misrepresentation, not pollution." The Court found that the pollution on which the insurer sought to rely "is too attenuated from the damages sought and the legal grounds supporting such alleged damages."

The appellate court specifically addressed the insurer’s argument that the broad preamble to the exclusion, precluding coverage for loss "based on, arising out of, or in any way involving" excluded pollution. The appellate court concluded that the damages sought in the securities lawsuit were neither "based on" nor "arising out of" excluded pollution. In concluding that the "in any way involving" wording similarly did not trigger the exclusion, the appellate court noted:

Read together with the surrounding words, "based on" and "arising out of," in the context of the pollution exclusion clause, "in any way involving" requires a more direct causal relationship between the pollution and the harm. [The insurer’s] interpretation of the pollution exclusion is too broad, unfair and contrary to the reasonable expectations of the insured.

The appellate court concluded that the "plain and ordinary language of the policy, as well as the reasonable expectations of the insured," prevent the insurer from precluding coverage.

Discussion

As a preliminary matter, it should be noted that the appellate court’s opinion is designated as "Not for Publication." Under Rule 1:36-3 of the New Jersey Rules of Court (here), "no unpublished opinions shall constitute precedent or be binding on any court." In addition, under the Rule, an unpublished opinion cannot be cited "unless the court and all other parties are served with a copy of the opinion and of all other relevant unpublished opinions known to counsel including those adverse to the position of the client."

While the appellate court’s opinion is therefore of no precedential authority and of only restricted persuasive potential, there are nonetheless lessons that can be derived from the case.

First, it should be noted that Sealed Air was able to establish its entitlement to coverage under the Policy for its defense expense incurred in defending against the securities litigation only after enduring a trial and subsequent appeal (and any other proceedings that the insurer may yet pursue in its attempt to deny coverage). It clearly is in the interest of any policyholders for their policy to clarify that the policy is intended to provide coverage for securities claims, even if the underlying misrepresentations alleged relate in some way to pollution.

In the current marketplace, many carriers will agree to provide a coverage carve back from the pollution exclusion specifying that the exclusion does not in any event apply to securities claims or to shareholders’ derivative actions.

In addition, in the current marketplace, many carriers will also agree to modify the exclusion’s preamble so that rather than the broad preamble wording found in Sealed Air’s policy, the preamble specifies that the exclusion applies only if the claim is "for" excluded pollution. This wording provides some measure of protection against carrier attempts to rely on remote connections between the actual claim against the insured persons and underlying facts involving pollution as a basis to deny coverage.

It should also be noted that certain of the so-called Side A/DIC policies available in the marketplace do not contain pollution exclusions. Depending on the coverage provided under these policies, the policies could potentially "drop down" and provide a measure of protection for individual defendants if the first line D&O insurer denies coverage for a claim based on the pollution exclusion.

One final note pertains to the underlying securities claim. I have previously commented (most recently here), about the possibility that growing social and political pressures relating to climate change issues could lead to climate change-related claims against directors and officers of publicly traded companies, particularly in connection with climate change-related disclosures. My views in this regard have met with some interest, but also with some skepticism.

The underlying securities lawsuit involved here demonstrates how shareholders might allege that a company did not fully disclose, for example, its contingent liabilities arising out of climate change-related issues. The Sealed Air case suggests (to me at least) how short the leap might be to these kinds of allegations. But the risk, however measured, underscores the need for the policy-wording issues identified above to be addressed.

An August 28, 2008 memorandum from the Wiley Rein law firm discussing the outcome of the Sealed Air coverage appellate decision can be found here.

Securities Docket: Bruce Carton of the Unusual Activity blog (here) has launched a new securities litigation news website called the Securities Docket (here). The Docket bills itself as a "globlal securities litigation and enforcement report." The first iteration is certainly visually attractive and full of a wide variety of interesting items. The Docket looks like it will be an interesting resource that we intend to monitor closely. Congrats to Bruce on getting the Docket launched.

WSJ RIP: Joe Nocera of the New York TImes has a post on his Talks Business blog (here) in which he mourns the death of the Wall Street Journal -- not the death of the newspaper itself, just its death as the repository of important business news. I have felt the same things that Nocera expresses for a while. The pre-Rupert Murdoch WSJ filled a valuable role that no one other paper (or other news source) plays. Now instead of a unique and indispensible source of business news, it is just one more source for stories about politics that have already been reported in any number of our media sources. I agree with Nocera --  I miss the old Journal a lot.

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

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

Background

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

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

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

The Coverage Litigation 

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

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

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

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

The Second Circuit Opinion 

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

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

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

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

Discussion 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

According to the press release, the Complaint alleges that:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The primary policy specifies that:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Coverage Denial:

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

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

The Coverage Litigation:

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

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

The June 18 Opinion

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

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

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

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

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

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

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

Discussion:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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