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

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

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

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

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

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

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

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

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

            What Are The Mechanics Of Applying A Narrowing Clause?

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

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

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

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

            Can A Narrowing Clause Be Applied To All Underlying Provisions?

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

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

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

            If Incorporated, Should Policy Provisions Be Interpreted Uniformly?

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

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

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

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

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

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

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

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

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

            Potential Solutions to Ponder

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

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

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

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

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

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One of the recurring D&O insurance coverage issues is the question of excess D&O insurers’ obligations when the underlying insurers have paid less than their full policy limits as a result of a compromise between the underlying insurers and the policyholder.

In the latest of a growing line of recent cases examining these issues, Judge Wayne Anderson of the Northern District of Illinois, in a June 22, 2010 opinion applying Illinois law, held that the "plain language" of the excess D&O insurance policies at issue required the actual payments of full policy limits in covered claims before the insureds could access the excess insurance.

Background

During the relevant period, Bally Total Fitness Holding Corporation carried a total of $50 million in D&O insurance arranged in five layers of $10 million each, between a primary insurer and four excess insurers. Bally and certain of its directors and officers were named as defendants in a securities class action lawsuit (about which refer here) in connection with which Bally incurred $33 million in defense expenses, for which Bally sought coverage under from its D&O insurers.

The primary insurer initiated an action in the Northern District of Illinois seeking a judicial declaration of noncoverage. Bally joined the excess insurers to the action as third-party defendants. Ultimately the primary insurer and the first and second level excess insurers reached a compromise by which they agreed to contribute a total of $19.5 million toward Bally’s defense expenses. The first level excess insurer settled for $8 million, $2 million less than its full policy limit. The second level excess insurer settled for $1.5 million.

The third and fourth level excess insurers refused to settle or otherwise contribute toward Bally’s defense expense. These two excess insures argued that the conditions precedent to coverage in their excess insurance policies had not been triggered. In making this argument, the third level excess insurer relied on its policy’s language that its payment obligations are triggered "only after the insurers of the Underlying Policies shall have paid, in the applicable legal currency, the full amount of the Underlying Limit." The fourth level excess insurer relied on language in its policy specifying that its payment obligations apply "only after all Underlying Insurance has been exhausted by payment of the total underlying limit of insurance."

The Court’s June 22 Opinion

In his June 22 opinion, Judge Anderson granted the third and fourth level excess insurers’ motions for summary judgment, finding that the plain language of their policies requires that the underlying insurers each "make actual payments of $10 million each in covered claims before Insureds can access coverage provided by the Third and Fourth Layer Excess Policies."

The insureds had argued that the third and fourth level excess policies were "ambiguous" as to whether the underlying policies had to make actual payment of a full $10 million each to trigger the top level excess carriers’ coverage. The insureds argued that the third and fourth level excess carriers had contracted to pay claims in excess of specified levels "regardless of who makes payment for covered claims" below those levels.

Judge Anderson considered the case law on which the insureds relied, particularly the 1928 Second Circuit decision in Zeig v. Massachusetts Bonding & Ins. Co.. In examining this line of cases, Judge Anderson concluded that "if an excess insurance policy ambiguously defines exhaustion, as in Zeig, courts generally find that settlement with an underlying insurer exhausts the underlying policies." However, Judge Anderson went on, "in cases where the policy language clearly defines exhaustion, the courts tend to enforce the policy as written."

Judge Anderson went on to find that the third and fourth level excess policies clearly defined how the underlying insurance must be exhausted prior to the insureds accessing coverage. Accordingly, and because the underlying insurance had not been exhausted by the underlying insurers’ payment of covered loss, Judge Anderson granted summary judgment in the third and fourth excess insurers’ favor.

Discussion

As a result of rising settlement levels and escalating defense costs, excess D&O insurance has become increasingly important in D&O claims resolutions. As more and more claims get pushed into the excess layers, more and more questions are arising, including this recurring question of whether the excess carriers’ payment obligations are triggered when the policyholder has compromised with the underlying carriers.

Judge Anderson’s holding in the Bally Total Fitness case joins a line of several recent cases in which courts have similarly held that, given the excess policy language at issue, the excess carriers’ payment obligation were not triggered when the underlying carriers paid less than their full policy limits as a result of a compromise with the policyholder. These recent cases include the July 2007 Eastern District of Michigan decision in the Comerica case (about which refer here) and the March 2008 California intermediate appellate court decision in the Qualcomm case (about which refer here).

The outcome of these various coverage disputes is a direct reflection of the excess policy language involved, and in particular the language specifying what is required in order for excess insurers’ payment obligations to be triggered. These cases underscore the critical importance of the language describing the payment trigger in the excess policy.

In recent months, and in large part as a reaction to these cases, excess carriers increasingly have been willing to provide language that allows the excess carriers’ payment obligations to be triggered regardless whether the underlying amounts were paid by the underlying insurer or by the insured. (I note as an aside that this language was not generally available at the time that Bally Total Fitness purchased the D&O insurance at issue in this case.)

The potential importance of the excess insurance payment trigger language, and the availability of language alternatives in the current insurance marketplace, in turn underscores the importance for policyholders of involving a knowledgeable and experienced D&O insurance broker in their acquisition of D&O insurance. The presence of the most favorable excess trigger language, among many other critically important policy language issues, could make a significant difference in the availability of coverage in the event of a claim.

Speedy Justice: According to Judge Wayne Anderson’s official biography (here), the Judge is the co-holder of the record for the 100-yard dash at Harvard University, from which he graduated in 1967.

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As I have noted in prior posts (most recently here), due to increasing average claims severity and escalating defense expense, excess D & O insurance is an increasingly important factor in the resolution of claims involving directors and officers of public companies. The greater involvement of excess D & O insurance has also meant an increasing number of claims disputes involving excess D & O insurers.

A recurring issue has been the question of the excess carrier’s obligations when the primary carrier has paid less than its full policy limits as a result of a compromise with the primary carrier. A March 25, 2008 opinion (here) by California’s intermediate appellate court held, that given the policy language involved, an excess D & O insurance policy was not triggered where the underlying insurer neither paid nor was obligated to pay its full policy limit of liability.

For the policy period March 15, 1999 through March 15, 2000, Qualcomm had $40 million of D & O insurance, structured with a primary layer of $20 million and an excess “follow form” layer of $20 million above the primary $20 million. During the policy period, Qualcomm employees and former employees brought lawsuits asserting rights to unvested company stock options. Qualcomm later settled these lawsuits and sought reimbursement from its D & O insurers for its defense expense and the settlement amounts.

Qualcomm ultimately reached a compromise with its primary D & O insurer, whereby Qualcomm gave the primary insurer a full policy release in exchange for the primary carrier’s payment of $16 million. Even with this $16 million payment, however, Qualcomm still had unreimbursed defense expense of $3.6 million and also had an additional unreimbursed $9 million in settlement expense.

In October 2006, Qualcomm sued its excess D & O insurer for breach of contract and declaratory relief, seeking compensatory damages as well as a judicial declaration that the excess carrier was obligated to indemnify Qualcomm for more than $9 million in unreimbursed expenses. The excess carrier contended, among other things, that the underlying policy had not been “exhausted” as required by the excess policy. The excess policy’s exhaustion clause provided that the excess carrier “shall be liable only after the insurers under each of the Underlying policies have paid or have been held liable to pay the full amount of the Underlying Limit of Liability.”

The trial court sustained the excess carrier’s demurrer (in effect, granted the carrier’s motion to dimiss) without leave to amend on the grounds that the excess policy had not been triggered, and Qualcomm appealed.

On appeal, Qualcomm argued that an excess carrier was liable for losses exceeding the actual limits of underlying primary insurance, even where the primary carrier settled for less than the actual policy limit. Qualcomm also argued that denying excess coverage in the circumstances presented would be contrary to public policy because such a denial would work a forfeiture, provide a windfall to the excess carrier, and encourage litigation by discouraging settlement.

The court of appeals declined “to reach a broad holding on public policy considerations” and instead concluded that “the literal policy language in this case governs.” The court said that the excess policy was not triggered because Qualcomm’s pleadings “establish that the primary insurer neither paid the ‘full amount’ of the liability limit nor had it become legally obligated to pay the full amount of the primary limit.” The court said that

the exhaustion clause here compels us to conclude that the parties expressly agreed that [the primary carrier] was required to pay (or be legally obligated to pay) no less than $20 million as a condition of [the excess carrier’s] liability. Because [the primary carrier] did not so pay, [the excess carrier’s obligations] did not arise.

The Qualcomm decision is consistent with the 2007 decision in the Comerica case, about which I wrote here, and which the Qualcomm court said presented “factual circumstances almost identical to those present in this case." This developing line of case authority has important implications both for the claims resolution and for the insurance acquisition processes.

Let me say at the outset that I am not attempting to criticize the position taken by the excess carrier in the Qualcomm case. Given the court’s ruling, it would be difficult to suggest that the carrier’s legal position was not well founded, and I do not propose to do so here.

In general, however, a claims outcome where a policyholder is stuck with millions of dollars of unexpectedly uninsured claims, after having funded a coverage gap as a result of a compromise with the primary insurer, and after having paid substantial insurance premiums, is highly undesirable from the policyholder’s perspective. Indeed, everyone involved in the D & O insurance industry, including ultimately even excess D & O insurers, has an interest in avoiding claims outcomes where policyholders gets “stuck,” as the value component of the insurance equation—the very thing that insurers’ sell – depends on the policyholders’ not getting “stuck.”

By the same token, the industry could be doing its customers and itself a service by keeping track of claims activity that produces adverse policyholder outcomes, whether it is a primary carrier that is hotboxing the policyholder into making a compromise or an excess carrier that is refusing to play along. Our industry could be improved were it to keep track of the carriers whose claims decisions result in policyholders getting “stuck” – by keeping track the industry might ensure that claims decisions involve not only detached legal analysis but also due consideration of the concrete business assumptions on which our industry ultimately depends.

At a minimum, it is increasingly clear that policyholders should consider only global compromises, involving all insurers, as any other arrangement could leave the policyholder exposed.

The Qualcomm decision has lessons for the policy acquisition process as well. The outcome in the Qualcomm case was a direct reflection of the excess policy’s exhaustion trigger language. While alternative language was not generally available at the time Qualcomm placed the D & O program involved in that case, many excess D & O carriers now offer exhaustion trigger language that reduces the restrictions on the kinds of payments that could trigger the excess carrier’s payment obligation. Indeed, many policies recognize payment by the policyholder as satisfying the underlying limit. The need for these issues to be address in the insurance placement process underscores the need to have skilled insurance professionals involved in the D & O insurance acquisition process.

Special thanks to John McCarrick of the Edward Angell Palmer & Dodge law firm for providing me with a copy of the Qualcomm decision. I should add that the views expressed in this post are solely my own.

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