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

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 advance