As I discussed in a recent post (here), in a June 11, 2013 opinion, the New York Court of Appeals held that J.P Morgan (which had acquired Bear Stearns) is not barred from seeking insurance coverage for a $160 million portion of an SEC enforcement action settlement labeled as “disgorgement,” where Bear Stearns’ customers rather than Bear Stearns itself profited from the alleged misconduct. The Court of Appeals opinion can be found here.
In the following guest post, Peter Gillon of the Pillsbury law firm offers his views about the Court of Appeals opinion in the J.P Morgan case, as well as about the decision’s implications. Readers are encouraged to add their comments on Peter’s guest post using the comment feature in this blog’s right hand column. I would like to thank Peter for his willingness to publish his article on this site. I welcome guest posts from responsible commentators on topics of interest to this site’s readers. Please contact me directly if you are interested in publishing a guest post. Here is Peter’s guest post:
In a case closely watched by industry observers, the New York Court of Appeals, in J.P. Morgan Securities v. Vigilant Insurance Company, No. 113 (NY, June 13, 2013), issued an important ruling in the field of Directors & Officers Liability Insurance, curtailing to some extent insurers’ ability to use a phantom exclusion to deny coverage. Insurers increasingly have argued that their policies do not cover damages that can be characterized as restitutionary in nature, even where the policy may be silent on the issue. The contention is based on two theories: (1) that notwithstanding contract language providing coverage, the policy is unenforceable in that respect because in some states coverage for damages in the form of restitution (or disgorgement of ill-gotten gains) is unenforceable as a matter of public policy; and (2) from an economic standpoint, when a policyholder returns monies it has obtained improperly, there is no basis for coverage because the policyholder has not incurred any “Loss.”
The New York high court called foul on this encroachment on policyholders’ contractual rights, holding that policyholder Bear Stearns was entitled to pursue its claim to coverage for a $160 million payment incurred as a result of settlement of an SEC enforcement proceeding, even though the agreement expressly characterized the payment as “disgorgement.” As the Court made clear, there is no public policy in the State of New York barring coverage for restitution or disgorgement; and the limited public policy exception to the enforceability of contracts for “intentionally harmful conduct” could not be sustained by insurers on the record before the court. (Slip Op. at 9-11). More important to policyholders, the Court also held that the bulk of the payment characterized in the settlement agreement as “disgorgement” was actually compensation for profits improperly received by Bear Stearns’ hedge fund customers, not the result of gain by Bear Stearns. Given that the “policy rationale for precluding indemnity for disgorgement – to prevent the unjust enrichment of the insured by allowing it to, in effect, retain the ill-gotten gains by transferring the loss to its carrier,” was not implicated because Bear Stearns was “not pursuing recoupment for the turnover of its own improperly acquired profits,” the Court denied insurers’ motion to dismiss. As Justice Smith put it during oral argument before the appellate court, “how can you disgorge something that you haven’t ‘gorged’?”
The ruling is critically important in that it curtails the use of the unwritten “restitution defense” by D&O insurers subject to New York law, unless the restitution payments at issue corresponded to benefits actually received by the insured. Under this test, the restitution defense would not apply to any claim, such as a claim for breach of fiduciary duties by directors or officers, where the individuals did not receive the benefit of a distribution or other transaction. Likewise, this matching test should limit use of the restitution defense in response to Side B claims (reimbursing a company for amounts paid as indemnity to individual directors or officers), where the company has paid restitution to a third party, but individual directors or officers did not actually benefit from the funds being disgorged.
Left unaddressed by the New York court, however, is one of the nagging issues in this area: whether the restitution defense requires the insurer to prove not only that the insured was the actual beneficiary of the amount being disgorged, but also that the gains were “ill-gotten.” In many cases, the recipient actually earned the amounts being disgorged, lawfully and properly, but is required to turn over its gains for technical legal reasons, regardless of fault. This may occur in a fraudulent transfer action brought by a bankruptcy trustee under Section 548 of the Bankruptcy Code (allowing avoidance of certain types of payments, such as severance payments to executives, made by an insolvent company less than two years prior to the bankruptcy petition date, in return for less than reasonably equivalent value). At least one court has held that in a fraudulent transfer action brought by a debtor company’s bankruptcy trustee against the company’s former CEO, the employee severance payment the CEO was ordered to disgorge did not constitute “Loss” within the meaning of the D&O policy. In re Transtexas Gas Corp., 597 F.3d 298, 310 (5th Cir. 2010)(“Payments fraudulent as to creditors that must therefore be repaid due to bankruptcy court order [are] a disgorgement of ill-gotten gains and a restitutionary payment.”). Other courts have rejected such an approach as an overbroad application of vague notions of public policy. In Federal Ins. Co. v. Continental Casualty Co., 2006 WL 3386625 (W.D. Pa. Nov. 22, 2006), a case arising from an action to recover alleged fraudulent transfers to former directors and officers under the Bankruptcy Code, the court refused to find that public policy rendered the preferential transfers uninsurable under state law. The court recognized that because liability in a fraudulent transfer action is strict, without regard to fault, “allowing the insured to collect under its insurance policy would not encourage others to intentionally engage in unlawful activity with the purpose of reaping a benefit from such activity through its insurance.” Id. at 23. The court observed that the insurance company already had a safeguard in place to prevent the insureds from reaping a windfall, namely, the Illegal Profit Exclusion. Id. Thus the court properly refused to second guess an expressly stated term of the policy based on public policy arguments.
In light of the J.P. Morgan ruling, insurers and insureds alike are well advised to take a fresh look at their policy wordings. The expanding use of the restitution defense, and the inherent difficulty in applying policy language to contractual terms such as restitution and disgorgement, strongly suggest that policyholders should demand clearer policy language. On the negative side, a few policies now expressly exclude restitution and disgorgement from the definition of Loss, without defining those terms. Some policies are silent and some exclude from Loss any damages that are uninsurable as a matter of state law. From a policyholder’s standpoint, it makes good sense to insist on coverage for restitution/disgorgement to the fullest extent insurable under the law, absent final adjudication that the disgorgement was to remedy illegal profit or criminal conduct. Even in the unlikely event that a state’s “public policy” would prohibit enforcement of such contracts, an insurer can surely stipulate in its policy that it will not assert that restitutionary damages are uninsurable unless there is a final adjudication of illegal profit or conduct. It is already widely accepted wording in almost every D&O policy (usually in the definition of “Loss”) that the insurer will not assert that (restitutionary) damages imposed under Sections 11 or 13 of the Securities Act are uninsurable as a matter of law; so this recommendation is in no way a “stretch.” Given the decade of litigation over these issues, for insurers to continue to assert this phantom exclusion instead of setting forth a clear statement in their policies is the real violation of public policy.
In a May 16, 2013 decision (here), Eastern District of Missouri Magistrate Judge Terry Adelman, applying Missouri law, determined that the failure of an insured under a management liability insurance policy to provide timely notice of claim precluded coverage under the policy, even in the absence of a showing of prejudice to the insurer.
On December 28, 2007, Secure Energy’s Board of Directors received a demand from Michael McMurtrey regarding commissions he allegedly was owed. On May 16, 2008, McMurtrey filed a lawsuit against Kenny Securities and against John Kenny, a director and founder of Secure Energy. On April 13, 2009, McMurtrey added Secure Energy as a defendant to the lawsuit. McMurtrey sought to recover $1.8 million in commissions and $2 million in punitive damages. McMurtrey alleged breach of contract, unjust enrichment, fraud, negligent misrepresentation, and conspiracy against Secure Energy. McMurtrey voluntarily dismissed his suit on June 25, 2009 but refilled it against the same defendants on July 8, 2009.
Secure Energy’s management liability insurance policy provided that the insured must provide notice of claim to the insurer as soon as practicable after becoming aware of the claim but no later than 60 days after the expiration of the policy. However, Secure Energy did not notify the insurer of the claim until May 4, 2011. According to the Magistrate Judge’s opinion, the reason for Secure Energy’s delay in providing notice was it was unsure whether it had a claim. However, the Magistrate Judge also noted that in 2009, the company’s insurance broker had advised the company that while there may be little or no coverage under the policy for the claim, the only way to determine coverage is to submit a claim.
The insurer rejected coverage for Secure Energy’s claim on the grounds of late notice. Secure Energy then filed an action seeking a judicial declaration that there was coverage for the claim under the policy. The insurer filed a motion for summary judgment arguing that coverage was precluded because Secure Energy had failed to provide timely notice. Secure Energy argued that coverage was not precluded because the insurer had suffered no prejudice from the untimely notice.
The May 16, 2013 Decision
In a short May 16 opinion, Magistrate Judge Adelman granted the insurer’s motion for summary judgment. Secure Energy had tried to argue that under Missouri law, an insurer cannot deny coverage for a claim based on late notice unless the insurer can demonstrate that the insured’s failure to comply with the notice provisions prejudiced the insurer. The insurer argued that under Missouri case law, in order to deny coverage on the basis of late notice, an insurer under a “claims made” policy need not demonstrate prejudice.
After reviewing the case law, Magistrate Judge Adelman observed that “the Missouri Supreme Court distinctly held that an insurer is not required to show prejudice in a ‘claims made’ policy. Several Missouri state and federal courts have followed this reasoning.” Magistrate Judge Adelman concluded that the insurer “is not required to demonstrate that it was prejudiced by Secure Energy’s failure to provide notice under the claims made policies. Secure Energy’s failure to give the requisite notice precludes it from coverage.”
Delayed notice is a recurring problem for policyholders seeking to obtain insurance coverage for claims. The reasons that the notice is delayed are innumerable. All too often, it will emerge that the reason the notice was delayed is that the policyholder did not think there was coverage or, as apparently was the case here, the policyholder did not think there was yet a claim. In other cases, the insured simply concluded that the claim was no big deal – only to find out later that it is a bigger problem than first appeared. Because I have seen these patterns so many times over the years, I have developed a simple rule – always give notice. No good comes from withholding notice. If you are asking the question whether or not you should give notice, then you should give notice.
But if policyholders sometimes hurt themselves by withholding notice, it can sometimes appear that some carriers in some instances seek to use the notice requirements as a coverage dodge. (Please note that in making this observation here, I am in no way commenting on the carrier’s behavior in the Secure Energy case.). For that reason, I am concerned when late notice can serve as a basis to deny coverage even in the absence of prejudice to the insurer. In fairness, the notice here was years late. The tardiness of the notice here is hard to excuse, particularly when two years prior to actually providing notice, the company had been advised by its broker to go ahead and give notice. But even here, the carrier does not appear to have prejudiced by the delay – or, at a minimum, did not claim to have been prejudiced by the delay.
The best way for companies to avoid problems with the notice requirement is to have processes to ensure that notice to the insurer is quickly provided after a claim has arisen. However, long experience has taught me that in the real world, the insurer is not always notified right away. The simple fact is that company management, particularly at some smaller companies, is focused on operational issues and is not always sophisticated about insurance issues. Courts evolved the “notice prejudice” rule in recognition of this practical reality.
I know that there are a number of jurisdictions where the courts have held that the “notice prejudice” rule is not applicable in the claims made context. I would argue that the “notice prejudice” rule has a place, even in the world of “claims made” policies. As I discussed in a prior post (here), some courts have applied the notice prejudice rule even in the claims made context (although, it should be noted, in that prior post, I noted some concerns with the court’s application of the rule in that specific case).
My concern is that without the application of the “notice prejudice” rule, the notice requirements can become a trap for the unsophisticated or uninformed insured and result in an inadvertent loss of the insured’s rights under the policy. I recognize that insurers want to be able to be involved in claims and don’t want to get caught up in murky questions about what may constitute “prejudice,” and therefore prefer a bright-line notice test. I would argue that the “notice prejudice” provides an appropriate balancing of interests. Obviously, the later a policyholder’s notice of claim is, the harder it would be for a policyholder to obtain coverage under the policy.
I know my friends on the carrier side may have differing views, and in particular may well contend that the notice provisions serve important purposes that should not lightly be set aside. I invite readers to add their views using this blog’s comment feature in the right hand column.
BlackRobe Litigation Funding Firm Shuts Down: In recent posts (most recently here), I have noted with alarm the apparently proliferation of firms in the U.S. formed to provide litigation financing. The firms are in the business of providing funding for litigation as a form of investment. Among the many developments in this area that captured my attention was the 2011 formation of BlackRobe Capital Partners. The firm’s principals included Sean Coffey, a former partner at the Bernstein Litowitz plaintiffs’ securities firm, joined a year later by retired Simpson Thacher partner Michael Chepiga. As I noted at the time, the involvement of highly respected attorneys like Coffey and Chepiga added an entirely new dimension to the emerging litigation funding phenomenon.
Now comes the news that BlackRobe is closing down. As reported in a May 14, 2013 Wall Street Journal article (here), the firm’s founders are “walking away from the litigation-finance firm, citing internal disagreements and a failure to attract enough outside capital from investors.” Though the firm has made over $30 million in investments, “the firm wasn't able to raise a large discretionary pool of capital.”
It is hard to know how much significance to attach to BlackRobe’s demise. On the one hand, a significant factor contributing to the firm’s closure were philosophical differences among the firm’s founders. On the other hand, the firm was also having trouble raising capital, which could suggest an overall lack of investor support for the litigation funding project. However, representatives of several more established litigation funding firm are quoted in the Journal article to the effect that their firms have had no difficulty raising money. So it is possible that BlackRobe’s quick end reflects nothing more than the difficulty that startups face in an evolving industry.
Susan Beck’s May 16, 2012 Am Law Litigation Daily article about the BlackRobe firm’s demise (here), includes comments from several of the firm’s principals that seem to corroborate the conclusion that firm’s end was in large measure the result of company-specific factors, including in particular differences among the firm’s principals about how to run the firm.
Although the demise of the BlackRobe firm unquestionably is noteworthy, it may or may not say anything about the emergence of the litigation funding phenomenon. Certainly the firm’s difficulties raising capital suggest that it may be a difficult field for startups. Overall, it seems that litigation funding will continue to be a factor, notwithstanding BlackRobe’s demise.
Libor Claimants Face High Hurdles: As readers of this blog know, the civil claimants attempted to recover damages against the Libor benchmark rate-setting banks have found the going difficult. For example, most recently the claimants in the Libor scandal-related securities suit filed against Barclays had their action dismissed (about which refer here). A May 16, 2012 Law 360 by Michael Gass, Stuart Glass and Kevin Quigley of the Choate Hall law firm entitled “Libor Litigation Must Overcome Significant Obstacles” (here, subscription required) reviews the various adverse litigation developments the Libor scandal claimants have had to face and concludes that the claimants’ “obstacles to recovery are inherent and, perhaps, insurmountable.”
Special thanks to a loyal reader for sending along a link to the Choate Hall memo.
Disputes over notice of claim requirements usually involve questions about the timing or content of the notice. A recent notice dispute involving UnitedHealth Group raised neither questions of timing or content; rather, the dispute involved the question of “to whom” the notice must be sent. In an April 25, 2013 opinion (here), District of Minnesota Judge Patrick J. Schlitz, applying Minnesota law, held that in order to satisfy the notice of claim requirements in an excess insurance policy, the notice had to be sent to the insurer's claims department as specified in the policy. Because the policyholder had failed to establish a genuine issue of fact whether the claims department had received the notice of claim, the Court granted summary judgment in favor of the excess insurer.
The dispute over the adequacy of notice arose in the context of a protracted and procedurally complicated action in which UnitedHealth is seeking insurance coverage from its insurers for a series of claims in which the company was involved between December 1998 and December 2000. The company’s primary insurance policy has been exhausted by payment of loss and the company has settled with five of its excess insurers. Four excess insurers remain as defendants.
In his April 25 order, Judge Schlitz considered a number of different motions in the continuing coverage litigation, including the motion for summary judgment of one of the remaining excess insurers, based on its assertion that it had not been provided notice of a claim known as the AMA claim. The AMA claim later settled for $350 million.
The notice provision in the excess insurer’s policy specified that:
It consideration of the premium charged, it is hereby understood and agreed that notice hereunder shall be given in writing to [the excess insurer], Financial Services Claims Department, 175 Water Street, New York, New York 10038 (herewritten the “Insurer”)
(a) The Company or the Insureds shall, as a condition precedent to the obligations of the Insurer under this policy give written notice to the Insurer as soon as practicable during the Policy Period, or during the Extended Reporting Period (if applicable), or [sic] any claim made against the Insureds.
According to the court’s opinion, the parties agreed that UnitedHealth had not provided written notice of claim sent to the specified address. UnitedHealth nevertheless argued that it had satisfied the notice requirements because it had “substantially complied” with the provisions. Judge Schlitz agreed with UnitedHealth that because Minnesota law “generally disfavors technical and narrow objections to the existence of coverage, especially when it comes to matters of notice,” substantial compliance is sufficient to satisfy a “to whom” notice requirement. But, he added, “substantial compliance requires notice that is substantial.”
Judge Schlitz disagreed with UnitedHealth that the “to whom” requirement is satisfied if the company “provides any kind of notice to any kind of agent” of the excess insurer. He found that under the policy’s provisions, the notice requirement “has not been substantially complied with unless the Claims Department received notice of claim – somehow, from someone --- during the policy period.” He added that if an agent of the insurer becomes aware of a claim “but the agent does not work in the Claims Department and does not notify the Claims Department of the claim, then there has not been substantial compliance with the ‘to whom’ requirement.” Judge Schlitz reasoned in that regard that:
“Compiance” with a provision of an insurance policy should not be deemed “substantial” if doing so would defeat the very purpose of the provision. And the very purpose of a “to whom” requirement – its entire reason for existing – is to ensure that notice is provided not just to the insurance company, but to a particular part of the insurance company. A large insurance company has a legitimate reason to require that notice of claim be given to a particular person or department with the company, rather than to any of the company’s thousands of employees and agents scattered around the globe. Otherwise, there is a substantial danger that the “notice” will not be recognized as such and will not serve its function.
Judge Schlitz added that “The Court can conceive of no reason why an insurer … should not be able to protect itself by requiring that notice be given to a particular person or department. And enforcing such a requirement does not place an onerous burden on an insured – particularly an insured such as United, which is itself a huge and sophisticated insurance company, and which has no excuse for failing to send notice of the AMA claim to the Claims Department, as [the excess insurer’s] policy clearly required United to do.” He concluded that in order for UnitedHealth to show that it substantially complied with the notice requirement, it must show that notice of the AMA claim was received by the Claims Department during the policy period.
Judge Schlitz then reviewed the various ways in which UnitedHealth claimed that it had provided notice of the claim. UnitedHealth argued that the AMA claim had been noticed in a monthly loss run report that the company’s broker supplied to the excess insurer and that the loss run report also was attached to UnitedHealth’s renewal insurance application. However, while Judge Schlitz found that there is sufficient evidence from which a jury could find that someone at the excess insurer received the loss runs, there was no evidence that that the loss runs were provided to the claims department.
And while the AMA claim apparently was discussed at a meeting in connection with UnitedHealth’s insurance renewal, there was no evidence that anyone from the excess insurer’s claims department had attended the meeting. Judge Schlitz specifically concluded that there was no evidence to suggest that the excess insurer’s claims department had received information about the AMA claims from the underwriting department.
Judge Schlitz also rejected UnitedHealth’s argument that because it had provided notice of claim to the primary insurer that is owned by the same insurance holding company as the excess insurer asserting the notice defense that the notice requirements had been satisfied.
Because UnitedHealth had “failed to show that there is a genuine issue of fact about whether the Claims Department received notice of the AMA claim during the policy period,” Judge Schlitz granted the excess insurer’s motion for summary judgment.
Judge Schlitz’s conclusion that an insurance notice requirement is not satisfied unless it can be shown that notice has been given to the specific department identified in the notice provision is a cautionary tale for practitioners in this area. In the press of day to day business, it would be far too easy for a notice to be sent to the right company but to a person, location or address other than the one specified in the policy. The clear lesson is that everyone involved in the process of providing notice of claim to needs to help to ensure that notice is sent not just to the correct insurer but also to the correct location – and to the correct location for each of the insurers in an insurance program. The case also underscores the value of having processes to require and obtain acknowledgement of receipt of notice of claim as well.
UnitedHealth’s apparent failure to provide the requisite notice of claim here is a little bit of a mystery. The claim was obviously very serious (or, at a minimum, it became very serious). It is clear from the Court’s opinion that the primary insurer on UnitedHealth’s insurance program was provided with the notice of claim required under its policy. It isn’t explained in the opinion how it came about the notice of claim had been sent to the prmary insurer (and apparentlyto other excess insurers as well) but not to the excess insurer involved in this motion. The court’s reference to the monthly loss runs is a reminder that UnitedHealth is a big, complex company that apparently became involved in a number of claims. The suggestion is that in the hubbub the notice of the AMA claim to this excess insurer somehow slipped through the cracks. Reading between the lines, there may also have been a confusion of or breakdown in responsibilities among the varaious process participants.
There is one aspect of this opinion that I find interesting. There is nothing in Judge Schlitz’s opinion to suggest that the excess insurer was prejudiced in any way by the absence of compliance with the policy’s notice provisions. At least as presented in the court’s opinion, it does not appear that the excess insurer argued that its interests had been prejudiced. The court was concerned only with the question whether or not the policyholder had satisfied the procedural requirements stated in the policy. There is no sense in the opinion of a consideration of a “no harm, no foul” point of view. .
The arguably harsh outcome of this dispute might be more comfortable if the analysis had been accompanied by some suggestion that UnitedHealth’s failure to satisfy the procedural requirements had somehow caused a problem for the excess insurer with reference to the AMA claim. Here’s my concern. Some insurers try to enforce their policies’ notice requirements as if the implementation of the provions were a game of “Mother May I?” On some occasions, some insurers brandish supposed notice issues as if, as a result of the supposed notice defect, they have won the game because the policyholder failed to say “Mother May !?” D&O insurers are of course fully entitled to expect compliance with policy requirements. However, reasonable business considerations should temper the enforcement of the requirements.
Judge Schlitz commented that it was fair to strictly enforce the requirements of the notice provision against a large sophisticated company like UnitedHealth. Whether or not that is true, my concern is that the same analysis as he is applying to a big sophisticated company like UnitedHealth could also be applied to a company that isn’t as big or sophisticated.
In all fairness, however, it should be noted that isn’t a case where a notice of claim as such was sent to the wrong address or the wrong department. Notwithstanding UnitedHealth’s arguments, it looks as if for whatever reason, there really was not a notice of claim as such sent to any address or department. Without that, UnitedHealth was left to argue that various fragments of informatoin about the claim could be shown to have filtered through a complex pattern of interaction between the company and the excess insurer. That was aloways going to present some difficulties for UnitedHealth. The company was not in the best position it could have been in on these issues.
As I said at the outset, this case is a cautionary tale for all of us working in this business. The lesson for all of us is to try to make sure that the notice of claim both goes to the specific address stated in the policy and that it goes to all of the insurers.
Ninth Circuit Reverses District Court Holding That E&O Insurance Policy Exclusion Precluded Coverage: On April 26, 2012, in a terse, unpublished four-page decision, a three judge panel of the Ninth Circuit reversed the district court’s dismissal of an insurance coverage action that Ticketmaster had filed against its error and omissions insurer. A copy of the Ninth Circuit’s opinion can be found here.
The errors and omissions insurance policy provided liability coverage for Ticketmaster for claims arising from the performance or the failure to perform professional services. The policy contained an exclusion, Exclusion E, specifying that the policy does not apply to any claim “based on or arising out of … any dispute involving fees, expenses or costs paid to or charged by the Insured.”
Ticketmaster was sued in a putative class action brought by ticketholders alleging that the company had made false representations regarding UPS delivery fees and order-processing charges for ticket events. Ticketmaster sought to have its E&O insurer defend it in the ticketholder claims. The insurer declined based on Exclusion E. Ticketmaster sued the insurer for breach of contract and bad faith. The district court granted the insurer’s motion for judgment on the pleading. Ticketmaster appealed.
In its April 26 opinion, the Ninth Circuit panel reversed the district court, holding that Exclusion E is “reasonably susceptible of at least two meanings, particularly in light of the Policy’s other 27 exclusions, and is thus ambiguous.” The appellate court identified the two possible meanings: “(i) Exclusion E may refer narrowly to a dispute regarding the monetary amount paid to or charged by Ticketmaster for uncontested services, or (ii) more generally, Exclusion E may refer to any dispute regarding a fee or charge for professional services, including a dispute regarding the relationship between services and the fees charged.”
The appellate court said that the E&O insurer had failed to carry its burden of showing that the second interpretation is the only reasonable one. The court noted that there are at least some allegations in the ticketholders’ action that do not involve the amount charged for uncontested services, such as the allegation that Ticketmaster performed no services in exchange for its order-processing charge. This allegation, the court said, did not dispute the amount charged but rather the relationship between any fee at all and the services provided. This dispute would be precluded by interpretation (ii) of Exclusion E but not interpretation (i).
The Ninth Circuit reversed the district court and reinstated the complaint, including Ticketmaster’s bad faith allegations.
FDIC Files Another Failed Bank Lawsuit and Two More Bank Fail: On April 26, 2013, the FDIC filed yet another lawsuit in its against the directors and officers of a failed bank. In its complaint (here), the FDIC, in its capacity as receiver of the failed Frontier Bank of Everett, Washington, has asserted claims for negligence, gross negligence and breach of fiduciary duty against twelve former directors and officers of the bank. The bank failed on April 20, 2010, so the FDIC filed its action just before the three-year statute of limitations expired.
The FDIC alleges that the defendants breached their duties to the bank by “causing the Bank to violate its own policies and prudent, safe and sound banking practices” in connection with the approval of at least eleven loans between March 2007 and April 2008. The FDIC sees to recover damages “in excess of $46 million.” An April 26, 2013 Puget Sound Business Journal article regarding the FDIC’s new Frontier Bank lawsuit can be found here.
Not only did the FDIC file the lawsuit against the former Frontier Bank directors and officers, but the agency also took over as receiver of two more failed banks on Friday. The two banks are the Douglas County Bank of Douglasville, Georgia and the Parkway Bank of Lenior, North Carolina. Between January 1, 2013 and April 20, 2013, there were only five bank failures total, but just in the last two weeks there have now been five more, for a total of ten so far during 2013. As I recently noted, though it has seemed as if the bank failure wave had just about played itself out, it now appears that there may yet be more bank failures yet to come.
With the failing of the latest lawsuit, the FDIC has now filed a total of 57 lawsuits against the former directors and officers of failed banks, including 13 so far this year alone. As I discussed here, it seems likely there will be more to come, as well.
Speakers’ Corner: On Tuesday, April 30, 2013, I will be participating in Advisen’s Quarterly D&O Claims Trends Webinar. In this free webinar, which will take place at 11:00 am EDT, I will be participating on a panel with Paul Ferrillo of the Weil Gotshal law firm, David Murray of AIG, and Jim Blinn of Advisen. The panel will discuss claims trends and developments during the first quarter of 2013. Registration information for the webinar can be found here.
On September 7, 2012, the Delaware Supreme Court, applying California law, held that Intel’s excess insurer’s defense obligations were not triggered where Intel had settled with the underlying insurer for less than policy limits and had itself funded the defense fees above the settlement amount and below the underlying insurer’s policy limit. A copy of the Court’s opinion can be found here. (Hat tip to the Traub Lieberman Insurance Law Blog for the link to the Court’s opinion).
Intel carried a multilayer tower of general liability insurance, consisting of a primary layer of $5 million, a first excess layer of $50 million, and multiple layers above that. Intel became involved in antitrust class action litigation triggering the insurance tower. Intel subsequently became involved in insurance coverage litigation with the first level excess insurer, which the first level excess insurer settled with a payment to Intel of $27.5 million. Intel funded its own defense expenses above that amount.
When its payment of defense expenses exceeded the remaining amount of the first level excess carrier’s limit of liability, Intel contended that the second level excess carrier’s defense obligations had been triggered. The second level excess carrier contended that its payment obligations could only be triggered by payments by the underlying excess insurer and that Intel’s own payments did not trigger payment. The second level excess insurer (hereafter, the insurer) filed an action in Delaware Superior Court seeking a judicial declaration that its payment obligations had not been triggered. The Superior Court granted summary judgment for the excess insurer, and Intel appealed.
On appeal, Intel argued that its defense cost payments were sufficient to trigger the insurer’s payment obligation. In making this argument, Intel relied on Condition H, which is titled “When Damages Are Payable” and provides that policy coverage “will not apply unless and until the insured or the insured’s underlying insurance had been paid or is obligated to pay the full amount of the Underlying Limits.”
In arguing that its payment obligations had not been triggered notwithstanding Intel’s payment of the defense expenses, the insurer argued in reliance on an Endorsement that had been added to the policy and that provided in Paragraph C that “Nothing in this Endorsement shall obligate us to provide a duty to defend any claims or suit before the Underlying Insurance Limits … are exhausted by payment of judgments or settlements.” The insurer argued that notwithstanding Intel’s payment of defense expenses, the underlying limit had not been exhausted by “payment of judgments or settlements.”
In affirming the lower court’s entry of summary judgment, the Supreme Court, in an opinion written by Justice Henry duPont Ridgeley for a five-judge panel, found that “Intel’s reading of the [insurer’s] policy purports to do exactly what Paragraph C of the Endorsement forbids: obligate [the insurer] to provide a duty to defend before exhaustion of the underlying …policy by payment of judgments or settlements.” The Court added that “viewing the policy language as a whole, Intel’s reading is untenable.” The Delaware Court also called Intel’s interpretation “strained.”
The Court specifically found that Paragraph C “cannot be construed under California precedents to encompass an insured’s own payment of defense costs.” The term “judgments” refers, the Court found,“to a decision by some adjudicative body of the parties’ rights” and the term “settlements” refers to “some agreement between parties as to a dispute between them.” Defense costs paid by the insured “do not fall within the plain meaning of either term.”
The Delaware court also referred specifically to the California Intermediate Court of Appeals decision in the Qualcomm case (about which refer here), in which the court held that payments of amounts by the policyholder did not suffice to exhaust the underlying insurance and trigger the excess coverage. Though noting that the Qualcomm case involved different policy language, “the implications of Qualcomm’s holding for this case are clear” – that is, that “plain policy language on exhaustion, such as that contained in Paragraph C, will control despite competing public policy concerns.”
The Delaware Court also concluded that because the “plain language of the policy control,” the venerable Zeig v. Massachusetts Bonding & Insurance Co. decision from the Second Circuit is “inapplicable.”
This Delaware decision joins a growing line of cases concluding --based on the language at issue requiring payment by the underlying insurer -- that the policyholder’s payments do not suffice to trigger an excess insurer’s payment obligation. (Refer here for the most recent discussion of the growing line of cases).
It is worth emphasizing that these cases are strictly a reflection of the policy language at issue. The excess policies certainly could provide that payment by either the insurer or the insured would suffice to exhaust the underlying insurance amounts and to trigger the excess insurer’s payment obligation. Indeed, more recently, many excess D&O insurance carriers have agreed to modify their policies to recognize payment either by the underlying insurer or by the insured as a trigger to the excess insurer’s obligation.
One of the interesting things about this case is that Condition H, on which Intel relied, did in fact expressly allow for the amount of the underlying insurance to be paid either by the “insured or the insured’s underlying insurance.” The Delaware Court, interpreting this provision (which is captioned “When Damages Are Payable”), said that it provided only that “Intel’s payment of damages may trigger [the insurer’s] duty to indemnify” (emphasis added). The Court went on to say that “nothing in Paragraph C suggests that Intel’s direct payment of defense costs may trigger (the insurer’s] duty to defend” (emphasis added).
That is, because the payment on which Intel sought to rely in arguing that the insurer’s payment obligations had been triggered was the payment of defense expenses (not damages), and because INtel was seeking payment from the insurer of defense expense (not damages), Condition H was irrelevant and only Paragraph C applied.
It is worth noting that Paragraph C had been added by endorsement, and it is fair to say the relationship between the various provisions and amendments is complicated. As the Delaware court itself noted, the “interplay” between the provisions “is admittedly complex.”
Insurance policies are of course complicated contracts with a variety of operating provisions. These provisions interact in complex ways, and when base forms are amended by endorsement, the interactions can become even more complicated.
Without in any way meaning to suggest that the policy at issue in this case did not reflect the intent of the parties to the contract, this case is a good illustration of how important it is to make sure that all of the various policy provisions are appropriately structured to that the interaction of the various provisions results in the intended outcome. Which is reminder that it is mportant in connection with the policy placement process that policyholders enlist the assistance of knowledgeable, experienced insurance advisors who understand the coverage and understand how various provisions and amendments will interact even the event of a claim.
On August 1, 2011, in a 2-1 decision characterized by a testy but interesting exchange between the majority and the dissent, the Sixth Circuit held that a fidelity policy provided coverage for nearly one million dollars a bank employee stole from client brokerage accounts. For those who (like me) are not regularly involved in fidelity claims, the two opinions provide an interesting opportunity to consider the purpose and operation of fidelity coverage and how it relates to general liability policies. The Sixth Circuit’s decision can be found here.
First Defiance Financial Corporation is a bank holding company. Jeffrey Hunt was a “dual employee” for First Defiance, providing investment advisory services to First Defiance customers and also trading securities for Online Brokerage Services. The clients’ assets were held in individual accounts at a third institution, National Financial Services. These client accounts were accessible only by First Defiance’s investment advisors, which acted as the “exclusive agent” on the clients’ behalf.
In April 2007, First Defiance learned that Hunt had transferred a total of about $859,000 from nineteen client accounts to his own bank account. First Defiance ultimately repaid the clients for their losses, including lost interest and unrealized client income. The total amount of First Defiance paid to the customers was about $930,000.
First Defiance provided a proof of loss to its fidelity insurer for the amount of its payment to the clients. The fidelity policy provides insurance against “[l]oss resulting directly from dishonest or fraudulent acts committed by an Employee, acting alone or in collusions with others.” In its Covered Property provision, the policy specifies that the policy covers “loss of Property (1) owned by the Insured, (2) held by the Insured in any capacity, or (3) owned and held by someone else under circumstances which make the Insured responsible for the Property prior to the occurrence of the loss.”
The fidelity insurer denied First Defiance’s claim for the loss, and First Defiance initiated a coverage lawsuit against the fidelity insurer. The district court entered summary judgment for First Defiance, holding that First Defiance’s loss was covered under the policy. The fidelity insurer appealed the coverage ruling. The parties also cross-appealed the district court’s calculation of the amount that the fidelity insurer owed. I do not discuss in this post the issues relating to the calculation of the insurer’s obligations.
The August 1 Opinions
In a majority opinion written by Judge Jeffrey Sutton for a divided Court, the Sixth Circuit affirmed the district court, holding that the fidelity policy covers First Defiance’s losses. Judge Deborah Cook dissented, writing a separate opinion that is well worth reading.
The crux of the majority’s opinion is its conclusion that the money in the client brokerage accounts represented Covered Property within the meaning of the fidelity policy. In reaching this conclusion, the majority determined that money in the brokerage accounts was “held under circumstances that made the insured responsible for the property” and that that responsibility arose “prior to the occurrence of the loss.”
The fidelity insurer had argued that First Defiance’s responsibility did not arise prior to the loss, and that First Defiance could have incurred liability only after Hunt stole the money, giving rise at most to a potential tort claim against the bank.
The majority rejected this argument, concluding that the definition refers to “responsibility” before the loss, not to liability, and that “the fiduciary relationship” between First Defiance and its clients “pre-dates the theft” making First Defiance “responsible for transactions undertaken with a client’s money from the moment the fiduciary relationship was formed.” The majority added that the bank’s responsibility “need not be established by a tort verdict, which necessarily cannot happen before the theft; it can be established by the terms of the account between the bank and the client and the fiduciary duties that spring from them.”
In her dissenting opinion that relies on policy drafting history and the purposes of the relevant language in the fidelity policy, Judge Cook characterizes the majority opinion’s policy interpretation as “simplistic.” Judge Cook asserts that “neither the policy language nor the history of fidelity coverage supports the majority’s view that the customer accounts constituted First Defiance’s ‘Covered Property.’”
Judge Cook focused specifically on the language in the definition of Covered Property requiring that the employer’s responsibility must vest “prior to the occurrence of the loss.” Judge Cook reviewed how this language had been added to the policy form to clarify that “a fidelity bond, unlike a general liability policy, provides no coverage for an employer’s vicarious liability for employee torts.” The provision, Judge Cook said, adds a “temporal element” requiring that “the insured’s responsibility for the stolen property must arise prior to the loss, not by virtue of vicarious liability.” First Defiance could have but did not assume responsibility for the risk of theft prior to loss “by placing [a] guarantee in its investment agreements with its customers.”
In an irritable response to the dissent, the majority opinion reiterates that First Defiance was “responsible” for money in the customer accounts at the time the accounts were opened, “long before –prior to—the loss of some money in those accounts cause by Hunt’s theft.” The majority opinion emphasizes that the policy does not require that the insured entity’s contract expressly state that insured entity undertakes responsibility for theft from customer accounts, but instead the policy requires only that “the ‘circumstances’ of the relationship must make the insured ‘responsible for the money before the theft.” In a dismissive characterization of the dissent’s position on this issue, the majority opinion adds the concluding comment that this question has been “Asked and answered.”
The critical issue here is the question of when First Defiance became responsible for the theft. Was it responsible for the theft from the moment the client accounts were created, or was it responsible only after the theft had taken place, on the basis of vicarious liability?
The question matters, because the answer to the question determines whether or not this loss properly belongs under a first-party policy like the fidelity policy at issue here, or more properly belongs under a third-party liability policy like a general liability policy.
Without presuming to suggest the right answer to this question, I will say that I found the dissenting opinion’s review of the history of the relevant language in the fidelity policy to be instructive. At least based on the sources referenced in the dissenting opinion, it seems that the language at issue here was added to the policy in order to clarify that the fidelity policy, unlike a general liability policy, provides no coverage for an employer’s vicarious liability for employee torts.
However, that observation does not alone answer the question of when the bank became responsible for the employee theft. On the one hand, I tend to agree that to agree with the majority’s common sense reasoning that the customer would certainly assume that the bank would be responsible for an employee theft from the customer’s account, and I also agree with the majority that as a practical matter its highly unlikely that there would be a written expression of this assumption in the bank’s agreement with the customer.
On the other hand, I tend to agree with the dissent that the expectation that the bank would be responsible for the employee’s theft simply reflects a general assumption that an employer is responsible for employee misconduct. If, for example, First Defiance had not voluntarily reimbursed the customers for their loss as a result of the theft and the customers had been forced to sue the bank, the customers would have, one way or the other, based their claims against the bank on some version of vicarious liability.
Framing the question in terms of that hypothetical lawsuit also seems to suggest that – even though the bank voluntarily made the customers whole – the payment to the customers was as a result of a third party liability claim.
All of that said, I would have a hard time subscribing to the dissent’s view of this case if the end result was that there was no insurance at all for this loss. I would be more comfortable altogether with the dissent’s position if I were sure that if the loss were not covered under the fidelity policy, it would be picked up under another policy. I would not be comfortable at all with the dissent’s position if it would result in the loss falling into a crease between policies. In particular, I would want to know whether or not the typical general liability policy would have in fact picked up this loss. Of particular concern is the possibility that a liability policy might preclude this loss because it was the result of an intentional act.
It would seem that, in a world in which there is little certainty, the safe thing for an insured organization to do in a situation like this is to submit a claim under both the fidelity and liability policies.
I am very interested to know the thoughts and reactions of readers who work more frequently with fidelity policies. I would like to know what others think of the majority’s position on these issues and also the dissenting opinion as well. I am also curious to know about what readers may think about the possibility that the possible coverage for this claim under a general liability policy. I encourage readers to post their comments to this post using the comment feature in the right hand column.
For those readers interested in a good quick introduction to fidelity coverage I recommend the Much Shelist law firm’s November 1, 2011 memo entitled “The ABCs of Fidelity Bonds: What Policyholders Need to Know” (here).
SEC, The Jury Has a Message for You: Many readers many be aware that on July 31, 2012, a civil jury in federal court in Manhattan acquitted Citigroup employee Brian Stoker on allegations that he had misled investors in connection with $1 billion of collateralized debt obligations. In a highly unorthodox accompaniment to the verdict form, the jury included a message to the SEC that “"This verdict should not deter the SEC from continuing to investigate the financial industry, to review current regulations, and modify existing regulations as necessary."
In his August 3, 2012 New York Times article entitled “Jury Gets Encouragement from Jury That Ruled Against It” (here), Peter Lattman reports, based on his interview of one of the jurors, how the note came about. As Lattman points out, the note seems to reflect common discontent that persons in the financial industry who were responsible for the excesses that contributed to the credit crisis have not been brought to account. As Alison Frankel notes in an August 2, 2012 post on her On the Case blog (here), for the SEC, the jury’s note “has to read like one more reminder that the public is still waiting for corporate accountability.”
In her August 1, 2012 Summary Judgment column on the Am Law Litigation Daily (here), Susan Beck has an interview with the foreman of the jury that heard Stoker’s case. From the foreman’s comments, it seems clear that the jury thought that while there was wrongdoing it was more in the form of collective wrongdoing of the company itself rather than that of one lower level individual. Beck quotes the foreman as saying that "He did not act in some kind of vacuum where his behavior was not tolerated or encouraged by his bosses. . .To try to hang all this on Stoker didn't work."
Frankel’s column has an interesting analysis of how the acquittal in the SEC’s case against Stoker may affect the long running saga of the SEC’s settlement of its enforcement action against Citigroup in connection with the CDO transaction. As noted here, Judge Jed Rakoff has rejected the settlement and refused to stay the case. More recently, the Second Circuit stayed the case pending an appeal of Rakoff’s rejection of the settlement, in an opinion that strongly suggested that Rakoff was wrong on the merits. Frankel suggests, among other things, that in the upcoming appellate arguments, the SEC may rely on the acquittal to show that the agency was wise to settle its case with Citigroup rather than test evidence that might not have withstood muster. On the other hand, the special counsel representing Judge Rakoff in the appeal may be able to argue (perhaps in reliance on the jurors’ comments in press reports) that the jury verdict actually reflected the jurors’ belief that there was misconduct among higher ups at Citigroup, and so Rakoff was right to reject the settlement.
There definitely is something about this case where every single thing that happens is interesting and worthy of commentary. It will in any event be interesting to see how the appeal regarding the erstwhile settlement unfolds. The appellate case is due to be argued in late September.
The Unintended Consequences of the JOBS Act: When Congress passed the Jumpstart our Businesses Startups (JOBS) Act earlier this year (about which refer here), it was hoped that the legislation would encourage “Emerging Growth Companies” and facilitate job creation. However, as discussed in Jason Zweig’s August 4, 2012 Wall Street Journal article entitled “When Laws Twist Markets” (here), things are playing out a little different than expected. As Zweig puts it “No matter how Congress monkeys with the laws, one always remains in force: the law of unintended consequences.”
By way of illustration, Zweig cites as an example of one company trying to take advantage of the JOBS Act’s streamlined IPO procedures and reduced reporting requirements the 132 year-old British football club, Manchester United, which hopes to launch its $300 million IPO next week. Zweig also refers to “blind pools” and “blank check” investment funds that are angling to take advantage of the JOBS Act’s provisions. Neither type of company is likely to contribute to job creation in the United States. Zweig also reports that at least seven Chinese companies are converting to JOBS Act reporting provisions, in order to be able to reduce the disclosures they are required to file; as Zweig points out, this is “no trivial matter since several other Chinese-based companies have recently been accused by U.S. regulators of filing misleading financial statements.”
As I have previously noted (here), a company’s status as an “Emerging Growth Company” arguably is for some companies itself a risk factor of which the company’s investors should be warned, particularly those companies taking advantage of the JOBS Act’s relaxed reporting requirements.
It should be noted that none of the comments above about the JOBS Act have anything to do with what may be the Act’s most distinctive feature, its allowance for online “Crowdfunding.” As I discussed here, the Act’s crowdfunding provisions were intended to facilitate fundraising for start-ups, but for many reasons, “crowdfunding is unlikely to be an attractive alternative for start-up companies.”
So far at least, it would seem the JOBS Act has produced only unintended consequences.
My New All-Time Favorite Headline: The headline for the lead article in the August 4, 2012 Detroit Free Press, regarding legal controversy surrounding Michigan’s emergency management law for financially troubled municipalities, reads simply “CHAOS” in four-inch high letters. (An online version of the article, sans the headline under which the story appeared in the print edition, can be found here.)
Given the financial condition of many of Michigan’s municipalities, and indeed given the ongoing developments around the world, the Free Press might well consider using that same headline every day. And newspapers everywhere else, too.
And Finally: I am an enthusiastic (if intermittent) fan of European football, particularly English Premier League football. Owing to this interest, I downloaded onto my iPad the Fan Chants app, which has recordings and lyrics of soccer fan chants from around the world. Some of the chants are rude and even profane, but overall the chants are highly entertaining. They can also be highly addictive; for example, since writing the paragraph above referring to Manchester United, I have been sitting here silently chanting to myself “Oh Man-ches-ter (Oh Man-ches-ter) is won-der-ful (is won-der-ful)…”
In contemplation of all of this, it somehow seemed appropriate to share this video clip of Sheffield United fans singing the “Greasy Chip Butty Song.” (A Chip Butty apparently is a sandwich consisting of French fries on buttered bread.) Here are the lyrics for those who can’t make out the words in the video:
One of the perennial D&O insurance coverage questions is whether or not subsequent claims are “interrelated” with a prior claim and therefore deemed first made at the time of the prior claim. This question can be particularly critical when the subsequent claims arose during a successor policy period; the answer to the “interrelatedness” question can determine whether the claims trigger one or two insurance programs.
In the wave of litigation that arose in connection with the subprime meltdown and the credit crisis, many of the organizations involved were hit with multiple lawsuits filed over period of time, and thus often presenting, in connection with the determination of the availability of D&O insurance coverage, the interrelatedness question.
A June 27, 2012 opinion in the D&O insurance coverage litigation arising out the collapse of IndyMac bank takes a close look at these issues. A copy of the opinion can be found here. In his opinion, Central District of California Judge R. Gary Klausner concluded, based on the relevant interrelatedness language, that a variety of lawsuits that first arose during the bank’s 2008-2009 policy period were deemed first made during the policy period of the bank’s prior insurance program, and by operation of two other policy provisions were excluded from coverage under the 2008-2009 program. Because of high profile of the IndyMac case and the sweeping reach of Judge Klausner’s opinion, his ruling could prove influential in the many of the other subprime and credit crisis cases presenting interrelatedness issues.
IndyMac failed on July 11, 2008. The bank’s closure represented the second largest bank failure during the current banking crisis, behind only the massive WaMu failure. (IndyMac has assets of about $32 billion at the time of its closure).
As I detailed in a prior post (here), the bank’s collapse triggered a wave of litigation. The lawsuits include a securities class action lawsuit against certain former directors and officers of the bank; lawsuits brought by the FDIC and by the SEC against the bank’s former President; and a separate FDIC lawsuit against four former officers of Indy Mac’s homebuilders division. There are a total of eleven separate lawsuits and claims pending. The first of these lawsuits was a consolidate securities class action lawsuit initiated in March 2007, which Judge Klausner refers to in his June 27 opinion as the Tripp litigation. (As noted in an accompanying post, the Tripp litigation has recently and separately settled.)
Prior to its collapse, IndyMac carried D&O insurance representing a total of $160 million of insurance coverage spread across two policy years, the first applying to the 2007-2008 period and the second applying to the 2008-2009 period. The insurance program in place for each of the two policy years consists of eight layers of insurance. Each layer has a $10 million limit of liability. The eight layers consist of a primary policy providing traditional ABC coverage, with three layers of excess insurance providing follow form ABC coverage, followed by four layers of Excess Side A insurance. The lineup of insurer involved changed slightly in second year.
In the insurance coverage litigation, the carriers in the 2008-2009 raised essentially three arguments: first, that the lawsuits and claims that arose during the 2008-2009 policy period were interrelated with the Tripp lawsuit, and therefore are deemed first made during the 2007-2008 policy period; that because the subsequent claims and lawsuits are interrelated with the Tripp lawsuit, which was noticed as a claim during the prior period, the subsequent claims and lawsuits are excluded from coverage under the 2008-2009 program under the applicable “prior notice” provision; and all of the subsequent claims are excluded from coverage under a specific exclusion endorsed onto the policies in the 2008-2009 program precluding coverage for claims related to the Tripp litigation. The former IndyMac officers and directors filed counterclaims contending that they were entitled to coverage under the 2008-2009 program. The various parties filed cross-motions for summary judgment.
The June 27 Opinion
In his June 27 opinion, Judge Klausner, applying California law, granted the insurers’ motions for summary judgment and denied the former IndyMac directors and officers cross-motions. Although his opinion is detailed, it boils down to his conclusions that each of the three sets of policy provisions at issue are unambiguous; that under each of the three sets of policy provisions, the subsequent claims are interrelated with the Tripp litigation; and by operation of the prior notice and Tripp litigation exclusions, all of the subsequent litigation is precluded from coverage under the 2008-2009 insurance program.
In concluding that the subsequent claims were interrelated with the Tripp litigation within meaning of the relevant language in the various policies, he noted that the policies’ definition of “interrelated wrongful act” is unambiguous and “describes a broad range of relationships between the original claim and other lawsuits that will be deemed as part of that same claim and made at the time of the first claim.”
The prior notice exclusion in the various policies, Judge Klausner noted, “describes a broad relationship between subsequent claims and claims that were made during prior policies such that these subsequent claims will be excluded from coverage.”
The Tripp litigation exclusion, Judge Klausner noted, is unambiguous and “excludes from coverage cases that have a broad range of relationships to the facts in the Tripp Litigation.”
Judge Klausner found that all of the subsequent claims and lawsuits “are sufficiently related to the Tripp litigation to be excluded under at least one clause of the [2008-2009] policies.” The set of allegations that Judge Klausner found to be common among the various claims and lawsuits was the assertion that IndyMac failed to follow its underwriting standards and the resulting alleged issuance of high risk mortgages. Judge Klausner found that this commonality extended among the various suits and claims even if the specific allegations in a particular claim or suit “may fall outside the temporal scope of the Tripp litigation.”
Judge Klausner’s opinion in this case is potentially significant, and not just because it means that the insurance under IndyMac’s 2008-2009 insurance program will not be available for the defense and settlement of the various subsequent claims. As I noted at the outset, many of the claims, lawsuits and disputes that have arisen in the wake of the subprime meltdown and the credit crisis present this same interrelatedness issue. Judge Klausner’s broad reading of the interrelatedness provisions, and in particular his willingness to interpret the policy provisions as not limited temporally but instead as having a broad meaning and reach, could prove influential.
It is important to note as an aside that Judge Klausner did not consider wording differences between the interrelatedness provisions in the “traditional” A/B/C policies and in the Side A policies in the 2008-2009 to be particularly significant (although, to be sure, he did note the differences). From an outcome determinative standpoint, the broad scope Judge Klausner gave to the interrelatedness provision could be the most significant feature. Because the interrelatedness language at issue, or substantially similar language, is found in most current D&O insurance policies, Judge Klausner’s analysis and the broad scope he gave to the policy language, could prove significant in a broad variety of other cases.
There is one aspect of Judge Klausner’s analysis that may limit its applicability to other disputes. That is that his ultimate conclusion that the various subsequent claims and lawsuits are precluded from coverage depended on the operation of all three of the policy provisions on which the insurers’ relied. It may be argues that it not enough for Judge Klausner to reach his conclusion that there is no coverage under the second tower that the subsequent claims were interrelated with the Tripp litigation; his conclusion that the subsequent claims were precluded from coverage also depended on the operation of the prior notice exclusion and the Tripp litigation exclusion arguably may distinguish this case from other interrelatedness disputes that may arise.
The practical effect of Judge Klausner’s decision is that there is insurance coverage, if at all, for the various subsequent claims under the 2007-2008 program. Although the 2007-2008 program represents a total of $80 million in insurance, the program has been eroded by over five years of attorneys’ fees in the Tripp litigation, as well as by the settlement of the Tripp litigation. The claimants in the various subsequent claims will now be in competition with each other for the remaining proceeds, while at the same time any amounts remaining will be further eroded by additional attorneys’ fees. The finite and dwindling amount of insurance and the sheer number of claims and claimants could make it challenging to resolve the claims and suits, at least to the extent insurance funds are to be involved. This observation is relevant to all claimants but it is probably worth noting that it is also applicable to the FDIC in connection with the two lawsuits the agency has filed in its role as IndyMac’s receiver against former officers of the bank.
A June 27, 2012 memo from the Wiley Rein law firm discussing Judge Klausner’s opinion can be found here.
I would like to thank the several loyal readers who sent me copies of this opinion. I appreciate everyone’s willingness to make sure that I am aware of significant developments so that I can pass them along to my readers.
In a November 30, 2011 order (here), Central District of California Judge R. Gary Klausner has denied the motion of the FDIC as receiver of the failed IndyMac Bank to intervene in a declaratory judgment action involving IndyMac’s D&O insurance. The FDIC sought to intervene because of its interest in recovering under the policies in connection with two lawsuits it filed as IndyMac’s receiver against former IndyMac directors and officers. Judge Klausner’s denial of the FDIC’s intervention motion may be relevant in other failed bank coverage disputes where the FDIC is interested in preserving D&O insurance policy proceeds for its claims in competition with claims of claimants to the policy proceeds.
IndyMac failed on July 11, 2008. The bank’s closure represented the second largest bank failure during the current banking crisis, behind only the massive WaMu failure. (IndyMac has assets of about $32 billion at the time of its closure).
As I detailed in a prior post (here), the bank’s collapse triggered a wave of litigation. The lawsuits include a securities class action lawsuit against certain former directors and officers of the bank; lawsuits brought by the FDIC and by the SEC against the bank’s former President; and a separate FDIC lawsuit against four former officers of Indy Mac’s homebuilders division. There are a total of twelve separate lawsuits pending. The underlying actions allege various improprieties, mostly centering around mortgage backed securities.
Prior to its collapse, IndyMac carried D&O insurance representing a total of $160 million of insurance coverage spread across two policy years. The insurance program in place for each of the two policy years consists of eight layers of insurance. Each layer has a $10 million limit of liability. The eight layers consist of a primary policy providing traditional ABC coverage, with three layers of excess insurance providing follow form ABC coverage, followed by four layers of Excess Side A insurance. The lineup of insurer involved changed slightly in second year.
As I also noted in a prior post (here), in early 2011, a unit of IndyMac had filed a declaratory judgment action seeking to establish coverage under the various policies in connection with claims that had been filed against the unit. In an August 2011 order, discussed in the prior blog post, Central District of California Judge R. Gary Klausner granted the defendants’ motion to dismiss the action as premature.
Separately, in March 2011, the four Side A carriers in the second of the two insurance towers filed their own separate declaratory judgment proceedings, against certain former IndyMac directors and officers, seeking to establish that terms in their policies preclude coverage for the various lawsuits. The directors and officers counterclaimed and also added as counter-defendants the four traditional ABC carriers in the second tower.
In October 2011, the FDIC, which in its capacity as IndyMac’s receiver has initiated two lawsuits against certain former IndyMac directors and officers of IndyMac, moved to intervene in the separate coverage action that the Side A carriers had initiated. The FDIC had moved to intervene on alternative grounds under the Federal Rules of Civil Procedure -- as of right; and alternatively under permissive intervention. The FDIC argued that because it is a plaintiff in the two underlying actions, it has an interest in seeing that the coverage dispute is resolved so that it can recover any eventual judgment in those actions out of the insurance proceeds.
The November 30 Ruling
In his November 30 opinion, Judge Klausner denied the FDIC’s motion to intervene. Judge Klausner held that the FDIC had not established its entitlement to intervene as of right because it “has not obtained a judgment against the Insured Defendants and may never do so,” and so presently it has at most “the hope of an eventual judgment.” Accordingly, he held, the FDIC has “no legally protected interest” in the coverage dispute.” He added that even if it had a legally protected interest, that interest is not related to the subject matter of the coverage lawsuit. Because the FDIC’s lawsuit against the former directors and officers and the separate insurance coverage action “involve different legal issues,” they are “not related for purposes of mandatory intervention.”
Judge Klausner held that FDIC’s alternative motion for permissive intervention also fails because the FDIC’s action against the former directors and officers, on the one hand, and the separate insurance coverage dispute, on the other hand, do “not present common questions of law or fact.” He added that because the FDIC has not yet obtained a judgment against the Insured Defendants it “does not have an interest that it needs to protect” and its claims “are not yet ripe for adjudication” and therefore it does “not have standing as a permissive intervenor.”
The FDIC’s interest in preserving its ability to collect the proceeds of a failed bank’s D&O insurance is not limited to this case. In connection with a host of other failed banks, the FDIC’s interest in the D&O insurance policy proceeds is in competition with the interests of a variety of other claimants, including in particular shareholders of the holding companies of the failed banks. The various parties will be in a race to try to see who gets there first, and if they can get there before the insurance is substantially or entirely depleted by defense expenses. The FDIC’s interest in taking part in coverage litigation makes perfect sense.
But so too does Judge Klausner’s ruling here. It appears that until the FDIC has reduced its claims to a judgment it may have difficulty presenting its purported claims to the D&O insurance policy proceeds in a coverage action. The question of whether or not there is coverage under a D&O policy for a given claim scenario is different from the question whether or not the FDIC has any entitlement to the policy proceeds.
Special thanks to my friends at Bates Carey Nicolaides LLP for providing me with a copy of Judge Klausner’s opinion. Bates Carey represents one of the insurers in the pending coverage action.
Between now and December 31, 2011, you can vote for your favorite among the top six business law blogs, by clicking on the ABA Journal Blawg 100 badge in the right hand column. Everyone here at The D&O Diary would appreciate your support. Thanks to the readers who make this blog possible and worthwhile.
Among the most contentious D&O claims issues are questions surrounding defense cost coverage, including in particular questions such as the allowable billable rates or the involvement of multiple firms. In a detailed November 8, 2011 opinion, Eastern District of California Judge Lawrence O’Neill, applying California law, addressed the hornets’ nest of problems involved when these kinds of questions arise. Though the disputes involved in this case are in some ways very case-specific, the case nevertheless provides (if only by way of negative example) a good illustration of how these questions might be avoided, managed or minimized. A copy of Judge O’Neill’s opinion can be found here.
Lance-Kashian & Company is the general partner of River Park Properties III (RPP III), which in turn was general partner of Park 41, a real estate partnership. In late 2008, Lance-Kashian’s D&O policy was up for renewal. The company’s risk manager directed that RPP III’s name be removed from the policy as a named insured. The D&O insurance policy that was in force for 2009 did not include RPP III as a named insured.
In late 2009, Lance-Kashian, RPP III, and certain Lance Kashian principals were sued in a bankruptcy court adversary proceeding by the Park 41 limited partner. The company notified its D&O insurer of the claim and asked the insurer’s permission to use the Cozen O’Connor law firm as defense counsel. In late December 2009, the insurer acknowledged receipt of the claim, reserved its right to deny coverage under the policy, and consented to the Cozen O’Conner firm’s involvement in the defense, but only at specified maximum rates (partner: $350/hour; associates: $250; paralegals, $150/hour). In light of the fact that RPP III was a defendant but was not an insured under the policy, the carrier proposed to allocate the defense fees between covered and non-covered parties, allocating one-third to the covered parties and two-thirds to the non-covered RPP III. The carrier argued in support of this proposed allocation that the bulk of the claims in the underlying complaint related solely or primarily to RPP III.
The carrier’s initial letter was the first in lengthy series of communications between the carrier’s counsel and the company’s risk manager. Judge O’Neill’s opinion details these communications, largely conducted by email. The parties later disputed the extent to which the communications either expressly or by silence amounted to the company’s assent to the allocation and defense counsel arrangements that the carrier has proposed.
At least part of the email exchange confirmed the carrier’s approval in the association in the defense of the Walter Wilhelm firm at the same specified maximum rates. In a separate email, the risk manager notified the carrier of the involvement of another firm, the Allen Matkins firm, which, the risk manager advised “would probably be used as an expert witness versus defense counsel.”
The company’s risk manager later submitted to the carrier invoices from the various law firms for payment. The invoices in turn set off an exchange about the aggregate level of fees, the involvement of multiple counsel, and concerns about the role of the Allen Matkins firm.
In January 2011, the underlying adversary proceeding finally settled. In connection with the subsequent coverage litigation, the risk manager submitted a declaration stating that the total defense expenses incurred in the case were “at least $1,557,295,” of which $618,251 was paid to the Allen Matkins firm; $475,000 was paid to Cozen O’Connor; $124,777 was paid to the Walter & Wilhelm law firm; and $144,133 was paid directly to third party vendors. At that point, the carrier had paid approximately $70,000 in connection with the defense.
The carrier initiated a civil action seeking a judicial declaration that it was only obligated to pay one third of the attorneys’ fees to which it had consented (that is, the Cozen O’Connor fees and the Walter Wilhelm fees) and only at the specified maximum hourly rates. The company disputed that the carrier was entitled to any type of allocation of the defense expenses or that any portion of the defense fees were not covered. The company counterclaimed, asserting claims of breach of contract and of breach of the covenant of good faith and fair dealing. The company asserted several arguments in reliance on various parts of the California insurance code, which the company asserted governed in light of the carrier’s provision of the defense subject to a reservation of its rights. The parties filed cross-motions for summary judgment.
The November 8 Ruling
In his November 8 ruling, Judge O’Neill granted the carrier’s summary judgment motion “to the effect that [the carrier] reasonably set and allocated defense costs for counsel to which it had consented.” First, Judge O’Neill concluded that while the carrier had consented to the involvement in the defense of the Cozen O’Connor firm and the Walter Wilhelm firm at the specified hourly maximum rates, “the insureds point to no specific request accepted by [the carrier] for Allen Matkins’ retention.”
Second, Judge O’Neill rejected the company’s argument that the carrier was obligated to reimburse all defense fees that were “reasonably related” to the insured persons’ defense. He concluded that the question was instead governed by the policy’s allocation provision, which specified that if a claim involved both covered and uncovered matters or parties, the insureds and the carrier would “use their best efforts to agree on a fair and proper allocation between insured and uninsured Loss.” The provision does go on to add: “However, [the carrier] shall not seek to allocate with respect to Claim Expenses and shall pay one hundred percent (100%) of Claim Expenses so long as a covered matter remains within the Claim.”
Judge O’Neill found that the record showed that the carrier “committed its best efforts to reach an allocation agreement, starting with the ROR letter and continuing with [its counsel’s] dogged efforts through numerous emails.” However, he added, “the same cannot be said for the insureds,” commenting further that “the inferences from the record are that the insureds devoted substantial efforts to attempt to settle the underlying action and decided to address allocation and insurance matter later.” There is, Judge O’Neill found “no evidence that the insureds used ‘best efforts’ to agree to an allocation.”
Judge O’Neill went on to reject the company’s argument that the final sentence of the allocation provision, allowing for a 100% defense cost allocation, obligated the carrier to pay 100% of defense costs. He found that the sentence obligated the insurer to pay only 100% of the defense costs of insured persons, but that the carrier has no obligation to pay the defense costs of persons who are not insured under the policy. Since the company and RPP III mounted a joint defense, the carrier is entitled to allocate the defense fees to remove the fees incurred on behalf of insured persons. Since the company “offered nothing meaningful” to “challenge” the carrier’s proposed allocation, and since “nothing in the record reveals that [the carrier’s] one-third allocation to the insureds was unreasonable or out of line with the insured’s potential liability,” he confirmed the carrier’s one-third allocation.
Judge O’Neill then turned to an unusual feature in the policy, which provided that the carrier’s determination as to reasonableness of claims expenses “shall be conclusive on the Insured.” He rejected the company’s argument that this provision is unconscionable, noting that “there is no conscience shocking that an insurer would seek to control defense and limit them to a reasonable range,” adding that the company was sophisticated and had the assistance of a full-time risk manager and broker, who bargained for the policy on the company’s behalf. He went on to note that “the insureds fail to demonstrate that [the carrier] was precluded legally to set the rates it would pay or that [the rates] were objectively unreasonable.”
There are a number of lessons from this dispute, which I review below. There are also a number of noteworthy holdings that are worth highlighting before moving on the moral of the story.
First, it is interesting and important that Judge O’Neill rejected the company’s efforts to try to rely on the “reasonably related” standard and instead enforced the allocation provisions in the policy. The “reasonably related” standard harkens back to an earlier time and place when D&O policies did not have express allocation provisions. Judge O’Neill’s enforcement of the provision shows that the allocation provisions themselves control – although his interpretation of the 100% Defense Cost provision is also interesting, in effect holding that the 100% allocation does not operate to require the insurer to pay the defense costs of parties who are not insured under the policy. In effect, he held that the 100% defense cost allocation applied only when there are both covered and non-covered matters, but not when there are both covered and non-covered parties. (Those involved in counseling policyholders on policy placement will want to consider this distinction in thinking about the optimal wording for these kinds of provisions.)
Second, Judge O’Neill enforced the unusual (and frankly onerous) provision giving the insurer’s determination of reasonableness presumptive weight. It may have been that he felt that a sophisticated company with competent advice had to accept the contract it had negotiated. (Again, those involved in negotiating policy placements for policyholders will want to note and watch out for this type of unusual provision.) By accepting the carrier’s presumptive right on the reasonableness issue, Judge ONeill avoided getting into the issue of whether or not the carrier’s insistence on its maximum hourly rates was reasonable. Too bad, that is an issue that in my view could use some ventilation.
Third, and perhaps most significantly in terms of the dollars involved, Judge O’Neill held that the carrier had no obligation to pay (even according to the allocation) for the defense fees and expenses to which the carrier had not consented.
This last point leads to the moral of the story – which is the importance of communication with the insurer at the beginning, during the course of, and at the end of the claim. A significant number of the problems the company faced in the coverage dispute were due to the way the company communicated with the carrier. Indeed, Judge O’Neill emphasized, and even quoted twice from, the deposition testimony of the company’s CEO that during the claim and amongst all of the other business challenges the company was facing he considered the questions the insurer was raising to be a “distraction.”
But the first of the lessons out of this coverage dispute comes from the deliberate move the company made at its insurance renewal to remove RPP III as an insured under its policy. This decision directly led to all of the allocation issues. The move clearly was not fully thought through because as soon as the claim came in naming both the company and RPP III, the company expected RPP III’s defense expense to be paid under the policy. This sequence shows the importance of thoughtfully addressing all potential coverage issues at the time of placement. Something as basic as who should be insured under the policy should be the subject of close consideration, and should be stress tested against likely claims scenarios. It isn’t just hindsight to say that even at the time of the renewal it was apparent that if there were to be a claim involving , say, Park 41, that both RPP III and the company would be named as defendants, and that both would require a defense. The company can bemoan the outcome of Judge O’Neill’s allocation analysis, but there wouldn’t have been an allocation in the first placed if RPP III had not been removed as a named insured under the policy.
The more generally applicable lesson is the importance of communicating fully and continuously with the carrier. The company here clearly understood that the carrier’s consent to defense expenses was required, yet failed to take the steps to obtain the carrier’s consent to the involvement in the defense of the Allen Matkins firm or of the third-party vendors who provided services in connection with the defense. This oversight was not a small matter since the fees of the Allen Matkins firm and the fees of the third party vendors together amount to almost half of all of the defense expenses that the company incurred. (It is probably worth noting that the company not only failed to keep the carrier informed but misstated the role of the Allen Matkins firm as being related to expert testimony, while disclaiming the firm’s involvement in the defense.)
The company may well have viewed the carrier’s questions and concerns as a “distraction,” but in the end the company paid a price for disregarding the carrier’s concerns. It certainly did not help the company that Judge O’Neill could find “no evidence” that the company used its best efforts to try to negotiate an allocation. By the same token, it clearly hurt the company that it did not voice its objection to the carrier’s proposed maximum rates as well as to the allocation. In the end, Judge O’Neill’s conclusions that the allocation and rates were reasonable were eased by the fact that while the claim was pending the company evinced little objection to the carrier’s positions in the regard.
Of course it is always easier to say in hindsight what a company should have done. I do not mean to find fault within anyone. But I think it is clear that the better course is to keep the carrier fully informed; to confront and address issues as they come up, not after the fact; and to work out as many issues as possible at the time, rather than later. It may not always be possible to avoid disputes, but dealing with issues as they come up may reduce the number of issues in dispute. And it will certainly help to avoid any later suggestion that “best efforts” were not used to try to work the issues out.
Finally, the best way to avoid unwelcome coverage outcomes is to make sure as many issues as possible are addressed in advance, at the time of the policy placement. As this case show, critical issues like the identity of named insured and the presence of unusual provisions (like the presumption of reasonableness for the carrier in this policy) are best addressed at the time the coverage is placed, to avoid problems later. This lesson in turn underscores the importance of the involvement in the policy placement process of knowledgeable and experience professionals who understand the kinds of issues that may be involved if claims later arise.
Special thanks to Michael Goodstein of the Bailey Cavalieri firm for providing me with a copy of Judge O’Neill’s opinion. The Bailey Cavalieri firm represented the carrier in this case. I hasten to add that the views expressed in the post are exclusively my own and should not be imputed to any other person, living, dead or otherwise.
Every now and then, I run across a case that makes me stop and say, “What?” I had that experience recently when I read the September 21, 2011 opinion of Middle District of Tennessee Judge John T. Nixon in an insurance coverage dispute involving Cracker Barrel Old Country Store, Inc. In the opinion, which can be found here, Judge Nixon held, applying Tennessee law and based on the policy language involved, that an EEOC lawsuit brought following employees’ discrimination charges was not a “Claim” within the meaning of the EPL insurance policy at issue.
Between December 1999 and March 2001, ten of the company’s employees filed charges alleging sexual or racial discrimination against the company with the Illinois Department of Human Rights and the EEOC. The company later provided notice of these charges to its EPL insurer. Thereafter, the EEOC brought suit against the company for multiple alleged violations of federal civil rights laws. The EEOC’s lawsuit arose from allegations of harassment and discrimination against former and current employees of the company, including the original ten charging parties. The company provided its EPL insurer with notice of claim relating to the EEOC lawsuit. The company later entered into a settlement decree with the EEOC, which designated $2 million to be placed in a settlement fund. The company incurred over $700,000 in defending the EEOC lawsuit.
The company sought coverage from its EPL insurer in connection with the EEOC lawsuit, seeking inter alia, reimbursement for its defense expenses. The carrier -- in reliance on the Policy’s definition of the term “claim” as “a civil administrative of arbitration proceeding commenced by service of a complaint or charge, which is brought by any past, present or prospective employee(s) of the ‘insured entity’ against any ‘insured’” – took the position that the policy did not cover the EEOC lawsuit. The company filed a declaratory judgment action and the parties filed cross-motions for summary judgment.
The September 21 Opinion
In his September 21 opinion, Judge Nixon granted the carrier’s summary judgment motion and denied that of the company. The carrier had argued that the EEOC lawsuit was not a “claim” within the meaning of the EPL policy because it was not brought by a past, present or prospective employee of the company. The company argued that the definition should be understood to mean that the proceeding must merely be commenced by a complaint or charge by an employee.
In ruling for the carrier, Judge Nixon found that the definition of “claim” in the carrier’s policy is
“not ambiguous” and that “the definition of a ‘claim’ has a clear meaning that a covered proceeding must be brought by an employee.” Even though the EEOC lawsuit followed from the employees filing of charges, the EEOC lawsuit “was not ‘commenced by the service of’ a charge, according to the plain meaning of that language, even though it may have arisen because of previous administrative charges.” The fact that “the EEOC charges on which the EEOC partially based its decision to bring a lawsuit were brought by Plaintiff’s employees is irrelevant.” Judge Nixon held that because “the EEOC lawsuit was not brought by an employee,” the lawsuit is “not a ‘claim’ under the Policies.” Accordingly, he ruled that the carrier did not have a duty to indemnify the company for the settlement amount or for the company’s costs of defense.
I think most readers’ initial reaction to this ruling will be surprise (at a minimum). The general expectation would be that the possibility of an EEOC lawsuit is among the very reasons companies buy EPL insurance. Indeed, as Judge Nixon noted in his opinion, the plaintiffs in this case argued that the insurance companies position that an EEOC lawsuit is not a covered claim “flies in the face of common sense,” as the company had purchased the EPL insurance “to protect itself from exactly the type of liability that results from EEOC actions,” which is, the plaintiff contended the “very purpose” of the coverage.
But what may seem like a surprising outcome may be nothing more that a reflection of the unusual wording in this policy. In his opinion, Judge Nixon noted that he had reviewed the language of EPL policies involved in other cases and that he had “found no instances where the relevant definition restricted claims to those ‘brought by an employee.’”
Indeed, my own quick review of the EPL policies of several other carriers show that many policies do not, as Judge Nixon noted, limit who must bring an otherwise covered claim. Other policies specifically include actions brought by the EEOC within the definition of claim, while yet others include the EEOC within the definition of a “claimant” whose action represents a “claim” under the policy. Many policies also allow that a claim may be brought “by or on behalf of” an employee. Judge Nixon found that in the absence of these kinds of provisions in the policy here, he could not interpret the provision as if it included that type of language, and that he “cannot find ambiguity where none exists merely because plaintiffs did not bargain for coverage that is expected.”
If nothing else, this outcome underscores the critical importance of policy wording. Where coverage for something as basic to EPL insurance as an EEOC lawsuit depends on the presence or absence of crucial words, policyholders must take steps to protect themselves, and in particular policyholders must enlist in their acquisition of insurance knowledgeable and experienced insurance professionals capable of ensuring that the policy language is matched to the policyholders’ needs and expectations. And while you wouldn’t think it would be necessary, it looks as if one item that should be attended to with particular care is to make sure that the EPL policy’s terms encompass EEOC lawsuit within the scope of covered claims.
More than once, I have suggested that part of the obligation of those who counsel insurance buyers is to develop a sort of league table for carriers’ claims handling practices. The carriers’ awareness of the maintenance of league tables might possibly encourage the carriers -- in considering whether or not to assert a particular coverage position -- to consider not only whether or not a particular position is analytically justified, but also consider how it might look to the insurance marketplace if the carrier were to take that position. Insurance professionals that maintain a claims handling practices league table may find it highly relevant that the carrier in this case was willing to take the position it took in this case.
An October 2011 memo from the Lowenstein Sandler law firm discussing this case can be found here.
Thank You for Your Support:The D&O Diary has been nominated as among the candidates for the LexisNexis Top 25 Business Blogs of 2011. The actual selection of the Top 25 blogs will take place at a later date. Among the considerations that will go into the selection will be the comments posted on the LexisNexis Corporate & Securities Law Communities site about the nominee blogs . Each comment is counted as a vote toward the supported blog. To submit a comment, visitors need to log on to their free LexisNexis Communities account. If you haven’t previously registered, you can do so for free by following this link. The comment box is at the very bottom of the blog nomination page. The comment period for nominations ends on October 25, 2011.
The options backdating scandal may now be ancient history, but questions surrounding insurance coverage for the scandal’s consequences apparently continue to live on. In a September 9, 2011 opinion applying Maryland law, Southern District of New York Judge Naomi Reice Buchwald ruled in a coverage action brought by SafeNet’s excess D&O insurer that, among many things, there is no coverage under the policy for SafeNet’s $25 million options backdating-related securities lawsuit settlement.
The opinion addresses a number of recurring policy issues, including questions of claim interrelatedness and relation back; imputation of fraudulent misconduct; application of the consent to settlement provision; and imputation of application misrepresentations for purposes of policy rescission.
Beginning in early 2006, SafeNet experienced a series of legal problems. These problems began with the company’s February 2006 announcement that it was restating prior financial statements. On May 18, 2006, the company announced it had received a subpoena from the U.S. Attorney as well as an informal inquiry from the SEC. Shortly thereafter, the company announced that it was forming a special committee to investigate its stock option granting practice. In September 2006 the company announced that the committee concluded that certain prior stock options had been accounting for using incorrect measurement dates and as a result its financial statements for the relevant periods would have to be restated.
These developments led to a variety of legal proceedings, including a securities class action lawsuits (about which refer here). There was also an SEC enforcement proceeding and a criminal investigation. The SEC proceeding resulted in the entry of a permanent injunction against the company’s former CFO, Carole Argo. Argo also pled guilty to a single count of securities fraud. The consolidated securities class action litigation was later settled for $25 million.
For the period March 12, 2005 to March 12, 2006, the company carried $15 million of D&O insurance, arranged with a primary $10 million layer, and a $5 million layer of insurance excess of the primary. For the period March 12, 2006 to March 12, 2007, the company also carried $15 million of D&O insurance, arranged in the same way as the prior year.
On February 28, 2006, the company sent its primary carrier a copy of the initial financial restatement disclosure. Both the primary carrier and the excess carrier accepted this letter as a notice of circumstances that might give rise to a claim. The company advised the carriers of the various legal matters as they later arose. The carriers took the position that all of the subsequent notices and claims related back to the initial notice of circumstances and therefore the various matters implicated only the 2005-06 policies, regardless of when the later claims may have been made.
Later, after Argo entered her guilty plea, the primary carrier advised the company that it was no longer entitled to coverage under its policy. The excess carrier advised the company that due to the guilty plea, “a declination of coverage is in order in certain respects” under the excess policy, and that “rescission of the policy may be appropriate.” The excess carrier asked the company to enter a tolling agreement.
SafeNet later settled the securities class action lawsuit and paid the settlement amount. In the later coverage action, the parties stipulated that the company did not notify the excess carrier of the settlement negotiations and did not seek the excess carrier’s consent to settlement. In the later coverage action, the company contended that it spent more than $20 million in defense costs for itself and the directors and officers, including more than $10 million in defense costs for directors and officers other than Argo.
The excess carrier filed an action against Safeguard, Argo and the company’s former CEO, Anthony Caputo., seeking a judicial declaration of its coverage obligations and seeking a rescission of the renewal excess insurance policy. The defendants filed a motion to dismiss arguing amount other things that the case could not proceed without the primary carrier as a party and arguing further that the case was premature because the primary policy had not been exhausted. In a December 7, 2010 order (discussed here, scroll down), Judge Buchwald denied the defendants’ motions to dismiss. The parties then filed cross-motions for summary judgment.
In her September 9 opinion, Judge Buchwald denied the defendants’ summary judgment motion and granted the excess carriers’ motion in part and denied the excess carrier’s motion in part. Among other things, Judge Buchwald agreed that all of the claims relate back to the 2005-06 policy and that only the 2005-06 policy was implicated; that any loss incurred by Argo was precluded from coverage by the policy’s fraudulent conduct exclusion, but that coverage for the company’s loss was not precluded by that exclusion; that because the company had failed to obtain the excess carrier’s settlement approval, there was no coverage under the excess policy for the $25 million securities class action settlement; and that to the extent that there is coverage under the renewal excess policy, the excess carrier was entitled to rescind the policy as to Argo and the company based on Argo’s application misrepresentations.
In contending that they were entitled to coverage under the 2006-07 renewal excess policy, the defendants had argued that the various option backdating problems were not even discovered until the middle of 2006 and therefore could not relate back to the February 2006 notification sent to the carriers. In rejecting these arguments, Judge Buchwald found that in the class action lawsuit, the financial irregularities disclosed in February 2006 and the stock options backdating were “part of an interrelated course of conduct.”
With respect to the policy’s relation back language, Judge Buchwald said that “these provisions make clear that the relation back of a claim turns upon the nature of the allegations in a subsequent Claim, not simply on the relationship in fact between an earlier notice of circumstances and a later Claim.” Because of the interrelationship between the two types of conduct and the “broad-relation back language” in the policies, she concluded that the subsequent matters relate back to the original notification and therefore only the 2005-06 policy was implicated.
Although she concluded that the fraudulent conduct exclusion precluded coverage for Argo, she concluded that the exclusion did not preclude coverage for the company. Even though policy language imputed “facts” and “knowledge” possessed by Argo to the company for purposes of determining the applicability of the exclusion to the company, the exclusion still does not apply to the company unless there has been an adverse judgment against the company. There was no adverse judgment against the company, and the judgment against Argo cannot be imputed to the company. Accordingly, notwithstanding Argo’s guilty plea and the imputation to the company of the facts and knowledge possessed by her, the exclusion does not operation to preclude coverage for the company.
However, the fact that the exclusion did not apply to the company does not mean that the company is entitled to coverage under the policy. Judge Buchwald concluded that the company was not entitled to coverage under the policy for the $25 million settlement because it had failed to get the carrier’s prior consent to settle. She said further that the she “could not conclude that the company was excused” from complying with the consent to settlement provisions.
As for the question of whether or not there was coverage under the policy for the more than $10 million the company incurred defending the directors and officers other than Argo, Judge Buchwald concluded that because there was no record evidence that the company had actually indemnified any particular director and officer and the state of the record is “undeveloped” she could not decide the question of coverage for the defense fees.
Finally, although she had concluded that SafeNet’s claims did not implicate the renewal excess policy, Judge Buchwald concluded that to the extent the renewal policy does apply, the excess carrier was entitled to rescission as to Argo and as to the company. She found that because Argo admitted to knowingly and with intent to defraud causing the company to file inaccurate public filing, the carrier was entitled to rescission was to her. Moreover, Argo’s knowledge was imputable to other insureds. And while the policy allows individual insureds to establish lack of actual knowledge, it does not allow the company to establish that it lacked knowledge.
This case is a veritable textbook of D&O Insurance coverage issues and Judge Buchwald’s opinion contains a number of rulings that could be important in many other cases.
Her ruling that the subsequent legal proceedings all relate back to the date of the initial notice, and therefore that only the 2005-06 policy is triggered, is likely to be of particular interest in many of the credit crisis related cases, in connection with many of which the insurance carriers are arguing that all of the various lawsuits filed against a particular company all relate back to a single, earlier policy year. Indeed that is the position that the carriers are taking in connection the Lehman Brothers lawsuits, as discussed in a recent post. The broad reading Judge Buchwald gave to the interrelated claim and relation back language here could prove to be very helpful for the carriers in many of these cases.
On the other hand, Judge Buchwald’s interpretation of the fraudulent conduct exclusion, and the limitations on what she was willing to impute to the company, will likely motivate carriers to quickly review their policy language to see whether the imputation provisions in their fraud exclusion require an adjudication of the fraudulent misconduct even when the fraud has been imputed. I suspect it came as a surprise here that if there was an adjudication of fraud as to Argo and that fraud was imputed to the company that the company could still retain coverage under the policy if the adjudication itself was not imputed to the company or there was otherwise no adjudication of the company’s fraudulent misconduct. I suspect many carriers are going to want to hold up their fraud exclusion and compare them to the fraud exclusion applicable here to see whether their fraud exclusion might operate as the fraud exclusion did here
As an aside, it is probably worth noting that Judge Buchwald was satisfied that a guilty plea represented an “adjudication” sufficient to trigger the exclusion. Perhaps that is a common sense interpretation, but I can certainly imagine the argument that a guilty plea is different from an adjudication, since there was no separate determination by a finder of fact, but merely an admission. Judge Buchwald’s conclusion that the guilty plea was sufficient would seem to undercut the argument that the exclusion could have said that an admission was sufficient to trigger the exclusion, but instead it required an adjudicated determination, which is different from an admission.
On the other hand, with respect to the topic of imputation, in her analysis of the rescission issues, Judge Buchwald found that Argo’s knowledge was imputable to the company under the applicable policy language. Thus Argo’s knowledge of application misrepresentations was sufficient to rescind coverage not only for herself but for the company as well. What observers may find most noteworthy about this is not just the imputation to the company but the fact that the application misrepresentations to which the imputation applied were in the form of misstatements in the company’s financial filings. In other words, the very financial misrepresentations that might attract a lawsuit might also wind up removing the company’s insurance coverage – at least where as here a senior corporate official has pled guilty to knowing fraudulent misrepresentation.
The final determination of significance in Judge Buchwald’s opinion is her conclusion that the company’s failure to obtain prior consent to settlement precludes coverage under the policy for the settlement. While a number of court have recently reiterated the enforceability of the consent to settlement clause (refer, for example, here), what is noteworthy here is that she found that the failure to obtain consent was not waived even where the carrier has said it has grounds to deny coverage, is contemplating rescission and has asked for a tolling agreement. The company undoubtedly felt like it had been left by the carrier to do the best it could to look after its interests, yet Judge Buchwald had found that the consent requirement had not been waive.
Judge Buchwald’s willingness to enforce the consent requirement even in these circumstances is yet another reminder of the critical importance of communicating with the carrier even under these types of strained circumstances. One protective step the company might have been able to take to avoid triggering a consent problem would be to obtain the carrier’s agreement that it would not raise the consent issue as an additional defense to coverage beyond those the carrier had said it believed it had grounds to assert.
Ad Nauseum: I was flipping channels earlier this week and I stopped to watch part of a major league soccer game. The field on which the game was being played had a billboard that said “Infinitum.” I idly wondered what product or service the billboard might be referring to, and then it hit me – the billboard is nothing less than an “ad infinitum.”
In an opinion that provides an interesting glimpse of a complex D&O insurance program, on August 24, 2011, Central District of California Judge R. Gary Klausner granted the motions to dismiss of the insurance company defendants in an action that had been brought by a subsidiary of IndyMac bank, which was trying to establish its rights to coverage under the failed bank’s D&O insurance policies. A copy of the August 24 opinion can be found here.
IndyMac failed on July 11, 2008. The bank’s closure represented the second largest bank failure during the current banking crisis, behind only the massive WaMu failure. (IndyMac has assets of about $32 billion at the time of its closure).
As I detailed in a prior post (here), the bank’s collapse triggered a wave of litigation. The lawsuits include a securities class action lawsuit against certain former directors and officers of the bank; lawsuits brought by the FDIC and by the SEC against the bank’s former President; and a separate FDIC lawsuit against four former officers of Indy Mac’s homebuilders division. According to Judge Klausner’s August 24 opinion, there are a total of twelve separate lawsuits pending (referred to in the opinion as the “underlying actions”). Judge Klausner describes the litigation generally as alleging “various improprieties, mostly centering around mortgage backed securities.”
IndyMac MBS was a subsidiary of IndyMac Bank, and is now wholly owned by the IndyMac federal receivership. IndyMac MBS is a defendant in a number of the lawsuits that have been filed in the wake of the bank’s collapse. Earlier this year, IndyMac MBS filed an action seeking a judicial declaration of coverage on its behalf under the bank’s D&O insurance policies.
The insurance policies at issue represent a total of $160 million of insurance coverage spread across two policy years. (Judge Klausner’s opinion does not explain why two policy year’s policies are potentially implicated, rather than only one.) The coverage in the 2007-2008 policy year, providing coverage during the year from March 1, 2007 to March 1, 2008, consists of eight layers of insurance. Each layer has a $10 million limit of liability. The eight layers consist of a primary policy providing traditional ABC coverage, with three layers of excess insurance providing follow form ABC coverage, followed by four layers of Excess Side A insurance.
The coverage for the policy year March 1, 2008 to March 1, 2009 is arranged similarly, except that the lineup of insurer involved changed slightly in the 2008-2009 program. Judge Klausner’s opinion names all of the carriers involved and their respective roles in the two programs.
In its declaratory judgment action, IndyMac MBS sought to have the court determine that each of the underlying actions is covered under one or the other of the two insurance coverage towers. Moreover, because the two programs are each subject to a “priority of payments” provision giving the individual defendants in the underlying actions priority to coverage under the policies, IndyMac MBS sought to have the court make a determination of coverage for the individual defendants in the underlying actions, so as to allow the court to ascertain whether IndyMac MBS may be eligible to receive coverage under the policies. The defendant insurance companies moved to dismiss.
In his August 24 order, Judge Klausner granted the insurance companies’ motions to dismiss, holding that IndyMac MBS’s request for declaratory relief is “too remote to constitute a case or controversy” because any insurance coverage that may ultimately be owed “can only be determined after the underlying actions involving the Individual Defendants have been concluded.” Accordingly, IndyMac MBS “does not yet have an adequate injury that would make this case justiciable.”
In addition, Judge Klausner found with respect to the excess layers of insurance had not even been triggered because the underlying insurance has not yet been exhausted, and whether the excess layers “will ever be triggered in the underlying action is too speculative to give rise to a valid request for standing in the current case.” Indeed, even under the primary policy, IndyMac’s alleged injury is “too speculative” as IndyMac MBS has not yet met the $2.5 million deductible.
Finally, Judge Klausner separately granted the Excess Side A insurers’ motion to dismiss. Because the insurance coverage under the Excess Side A policies is only available, if at all, for the benefit of the individual defendants, IndyMac “lacks standing to request declaratory relief” because it “cannot adequately allege that it has a legal interest” in the Excess Side A policies, given that the Excess Side A policies “provide coverage only for the Individual Insured Defendants.”
There is nothing surprising about the outcome of this ruling. It clearly is too early for the court or anyone else to try to sort out who is going to be entitled to what under the various policies. Nevertheless, it certainly is understandable that IndyMac MBS would want to know how much insurance it is going to have as it faces the various lawsuits in which it is involved.
This is a classic situation of too many claims, too many defendants and possibly not enough insurance. Even though IndyMac carried annual limits of liability of $80 million (and I note as an aside, there is nothing that says that both of the two $80 million towers of insurance will actually be available; it is entirely possible that all claims will relate back to the date of the initial filing of the first claim, in which case only a single $80 million tower would actually be available to pay the various insured persons’ losses), that may prove to be an insufficient amount to pay the defense fees and to pay settlements and judgments in order to resolve all of the various underlying actions.
The larger concern for IndyMac MBS is that owing to the priority of payments provision in the traditional ABC policies, and owing to the limitation of coverage in the Excess Side A policies to the individuals only, it is entirely possible that payment of the individual insureds’ defense expenses and settlement amounts will entirely exhaust all insurance. The Excess Side A insurance of course is not available at all for IndyMac MBS. IndyMac’s declaratory judgment action seems like an attempt to try to do something before all of the insurance is gone.
Of course, I am assuming for the sake of argument that there actually is coverage available under these policies for the benefit of the individual insured persons. Whether or to what extent there are policy terms and conditions that preclude coverage in whole or in part for the individual insureds is another question. That is of course one of the questions that IndyMac MBS wanted answered in the declaratory judgment action, because knowing the answer to the question of how much insurance is available to the individuals is a necessary predicate to knowing the answer to how much insurance might be available to IndyMac MBS.
The structure of IndyMac’s insurance was somewhat unusual, as it is not common for companies to carry equal amounts of traditional ABC insurance and of Excess Side A insurance, or to carry $40 million of Excess Side A, as IndyMac did here. However, from the perspective of the individuals, the unusually large amount of Excess Side A insurance that the bank carried is turning out to be a good thing from there perspective, as it is looking like they are going to need it, and it is only going to be available to them and for their benefit, without having to share with other entities.
Anyway, while I don’t think the outcome of this decision is particularly surprising, it is still an interesting situation. The circumstances provide insight into the ways that the various parts of a D&O insurance program operate, particularly the priority of payments provision and the Excess Side A insurance structure.
One final observation has to do with the fact that a lot of insureds, like IndyMac MBS, become frustrated when they are unable to find out with clarity at the outset of a claim how much insurance is going to be available. The problem is, as this case demonstrates, until the underlying litigation has played itself out, it is not possible to know how all of the various rights and interests under the policy are going to be addressed. When this type of frustration arises in the course of a claim, the insured persons often translate their frustration into anger at the carriers involved. But as this case also shows, even taking as active a step as suing the carriers to try to force a determination of coverage cannot eliminate the unavoidable constraint that requires the underlying claim to be resolved (or at least sufficiently advanced) before coverage can finally be determined.
I do wonder sometimes whether it is a sad commentary that I find all of this interesting.
Special thanks to a dedicated reader for sending me a copy of the IndyMac order.
Las Vegas Sands Credit Crisis-Related Securities Suit Survives Dismissal Motion: Like a lot of companies during the economic turmoil in late 2008, the Las Vegas Sands Corp. experienced serious liquidity problems that put it in breach of various covenants it has with its lenders. These disruptions affected the company’s ability to proceed with expansion plans in Las Vegas and Macao. As these events unfolded the company’s share price lost much of its value.
As I discussed in an earlier post, somewhat belatedly, in May 2010, a plaintiff shareholder filed a securities class action lawsuit in the District of Nevada, alleging that the company and certain of its directors and officers had made misleading statements about the company, its development plans, its liquidity and its financial condition. The defendants moved to dismiss.
In an August 24, 2011 order (here), District of Nevada Judge Kent Dawson denied the defendants’ motion to dismiss. He concluded that the plaintiffs “have adequately pled facts asserting that investors were misled by statements that liquidity was not an issue and that development was steadily progressing.” He also concluded that the plaintiffs have “adequately pled that Defendants knew that the statements they were making were false.” He also found that the allegations in the complaint “show a series of public statements on material issues that were inconsistent with what was known internally.” He did conclude that certain forward-looking statements were not actionable, because they came within the safe harbor for forward looking statements.
I have added the Las Vegas Sands case to my running tally of credit crisis-related dismissal motion rulings, which can be accessed here.
Here’s A Real Shocker: Merger Objection Lawsuits Are Worthless: If the hurricane blew away your Saturday newspapers, you may not have seen the August 27, 2011 article in the Wall Street Journal entitled “Why Merger Lawsuits Don’t Pay” (here). According to the article, “legal experts” warn prospective claimants with respect to merger objection lawsuits that “the chances that you will succeed in stopping a deal or receiving a payday are minimal.”
The article reports data from Advisen that in 2010, there were 353 merger objection lawsuits, which represents a 58% increase from 2009. There have already been 352 merger objection lawsuits so far this year. The number of these lawsuits keeps increasing even though these suits “rarely result in a tangible award,” and the best outcomes are usually limited to “a delay in the merger or slightly improved disclosures about the deal’s terms.”
The answer to the question about why these cases are filed if they produce so little is that they make money for the lawyers. As the article puts it, “in many cases the biggest beneficiaries are the law firms,” which collect fees “from roughly $400,000 for typical cases to several million for bigger cases.” The article quotes a statement from Delaware Chancellor J. Travis Laster that the specific merger objection case before him was “a bunch of movement for nothing.”
Yes, it’s a great country, isn’t it?
Video Tribute: As a parting salute to Irene as she heads north and back out to sea, here's a video tribute -- The Scorpions "Rock You Like A Hurricane." (sorry about the commercial at the beginning, it is short).
On August 22, 2011, when the FDIC filed a lawsuit related to the collapse of Silverton Bank, which is Georgia’s largest failed bank, the named defendants included not only bank officers that the regulators allege are responsible for the bank’s failure, but also the bank’s former outside directors and even the bank’s D&O insurers. A copy of the FDIC’s complaint, which was filed in the Northern District of Georgia, can be found here. Scott Trubey’s August 22, 2011 Atlanta Journal Constitution article about the lawsuit can be found here.
In addition, and as discussed further below, on August 23, 2011, the FDIC separate filed an action in the District of Arizona against certain directors and officers of the failed First National Bank of Nevada.
When Silverton failed on May 1, 2009, it had assets of over $4 billion. Prior to its collapse, Silverton had done business as a “banker’s bank” and had been chartered to do serve the needs of community financial institutions, by providing correspondent and clearinghouse services. The bank eventually expanded into residential and commercial real estate acquisition and development loans, which it accomplished through “participations” in which the Bank shared funding and risk with other banks.
The FDIC’s complaint alleged that its case represents “a text book example of officer and directors of a financial institution being asleep at the wheel and robotically voting for approval of transactions without exercising any business judgment in doing go.” The complaint, which seeks recovery of damages of $71 million, asserts claims against the individual defendants for negligence, gross negligence, breaches of fiduciary duty and waste.
The individual defendants named in the lawsuit include not only the bank’s former President and CEO and two other former bank officers, but also 14 additional former outside board members. In naming the outside directors, the FDIC stressed that what makes this case “so unique and troubling” is that the bank’s board was not composed of “ordinary businessmen” but, rather, in view of the bank’s business as a banker’s bank, of individuals who were all CEOs or presidents of other community banks. These outside board members “by virtue of their elevated positions within their own banks, were more skillful and possessed superior attributes in relation to fulfilling their duties” than “others who may serve in this capacity.
The complaint alleges that the individual defendants allowed the bank to pursue a strategy of rapid expansion, particularly with respect to commercial real estate lending, just as the economy started to head south, and allowed the bank to continue to pursue this strategy even after the signs of economic problems began to mount. The complaint alleges that the bank’s “aggressive banking plan” was accompanied by weaknesses in loan underwriting, credit administration and a complete disregard of a declining economy, which “led to the failure of the Bank.”
The complaint also alleged that the individual defendants “directed the Bank on a course of expansive and extravagant spending on unnecessary items for the Bank after the economy began to decline.” The individual defendants are alleged to have “authorized the purchase of two new aircrafts, a new airplane hanger to house three large and expensive airplanes, and a large and lavish new office building.”
In addition to naming the former officials of the failed bank as defendants, the complaint somewhat unconventionally also names as defendants the bank’s two D&O insurers.
At the time the bank failed, it carried a total of $10 million of D&O insurance, arranged in two layers consisting of a primary layer of $5 million and an additional $5 million layer excess of the primary. The complaint relates that when the binder for the relevant primary policy was issued on March 3, 2009 (that is, less than two months before the bank failed), the binder listed ten endorsements, including an endorsement containing the so-called regulatory exclusion (for background about the regulatory exclusion, refer here). However, when the primary carrier issued the policy on April 1, 2009, only seven of the ten endorsements that had been listed on the binder were included on the D&O policy. Among the endorsements that were listed on the binder that were not included on the issued policy was the endorsement with the regulatory exclusion.
On the afternoon of May 1, 2009 (that is, the day Silverton was closed), a representative of the primary carrier sent an email message that he “had noticed that the Regulatory Endorsement was on the Binder but left off the policy in error,” and attached to the email an endorsement with the Regulatory Endorsement dated May 1, 2009 but with an effective date of March 9, 2009. The complaint characterizes this as a “last minute attempt to unilaterally change the terms of the Policy.” The complaint further alleges that policy issuance terminated the binder.
The FDIC’s complaint seeks a judicial declaration that the regulatory exclusion is not a part of the primary or excess policy, and that the Insured vs. Insured exclusion, on which the carriers also purport to rely to deny coverage, does not preclude coverage for the claim. (Refer here for a discussion of the issues surrounding the applicability of the Insured vs. Insured exclusion in connection with a claim involving the FDIC as receiver.)
The FDIC’s lawsuit against the former Silverton directors and officers is not the first lawsuit filed as part of the current round of bank failures in which the FDIC has included outside directors as defendants. For example, the lawsuit the FDIC recently filed in connection with the collapse of Haven Trust included the failed bank’s former outside directors as defendants, as discussed here. The FDIC seems to have particularly targeted the outside directors of this failed bank, owing to the unusual circumstance that former directors were all themselves also senior executives of other banking institutions. The FDIC clearly intends to try to bootstrap this fact in order to argue that these specific directors should be held to a higher standard of care. (My recent post on issues surrounding questions of bank director liability can be found here.)
Upon reflection of the unique circumstances by which these directors came to be on the Silverton board, it occurs to me that the FDIC may have certain additional motivations in pursuing claims against the former outside directors of the bank. The parrticular circumstance I have in mind is the fact that each of these outside directors of Silverton was also an officer of another banking institution. To the extent these individuals were serving on the Silverton board at the direction of the sponsoring institution, these individuals potentially could have coverge for claims in connection with their Silverton board service under the outside director liability provisions of their sponsoring bank's D&O insurance policies. I am expressing no views on whether or to what extent such coverage actually would be available, nor could I without further information about their sponsoring banks' D&O insurance policies and about the circustances by which they came to be on the Silverton board. My purpose in noting the observations here is simply to suggest this possible additional motivation that the FDIC might have in pursuing claims against these particular outside directors. In any event, the outside director liability coverage, if any, under the sponsoring company's D&O insurance may be limited to outside director service on nonprofit boards.
The FDIC’s inclusion of the D&O insurers as parties defendant in the liability lawsuit is unorthodox to say the least. One the one hand, as the complaint recites, the D&O insurers have denied liability for the FDIC’s claim, which might set the predicate for a more conventional (and separate) declaratory judgment action against the carrier. From reading the complaint, it seems that the primary carrier’s belated attempt to correct the omission of the regulatory exclusion from primary policy may explain the FDIC’s more aggressive approach here.
Whatever else may be said about the FDIC’s inclusion of the insurers as defendants in this lawsuit, the alleged facts provide a veritable parable about the importance of making sure that the issued policy matches the terms of the binder. It will be interested to see how the Court addresses what allegedly appears to be a policy issuance error, as the insurance arrangement to which the parties had agreed unquestionably was intended at the time of contract formation to include a regulatory exclusion. For that matter, it will be interested to see whether the Court permits the coverage action to remain joined with the underlying liability action, and whether or not the Court will permit the two related actions to go forward at the same time.
FDIC Also Files Lawsuit Against Former Officials of First National Bank of Arizona: In addition to its new lawsuit against the Silverton officials, the FDIC also filed a separate lawsuit in August 23, 2011 in the District of Arizona against two former directors and officers of First National Bank of Arizona, which had been one of the sister banks of First National Bank of Nevada until they merged shortly before FNB Nevada failed. FNB Nevada was among the first banks to fail as part of the current round of bank falures when it failed on July 25, 2008. A copy of the FDIC's complaint in the case can be found here.
The complaint alleges breach of fiduciary duty, negligence and gross negligence against the former officers, asserting that they cause the bank to sustain "losses from the unsustainable business model they promoted for FNB Arizona's loan portfolio -- a model that depended on real estate values rising indefinitely and low defaule rate." The complaint alleges that "when the real estate market collapsed and default rates skyrocketed, FNB Arizona was left holding millions of dollars of bad loans it could not sell." The FDIC alleges that as a result of the defendants' conduct, the FDIC has sustained losses in excess of $193 million.
The Current FDIC Failed Bank Lawsuit Count: These complaints represent the tenth and eleventh that the FDIC has filed against former directors and officers of a failed bank as part of the current round of bank failures. The Silverton lawsuit represents the third so far in Georgia. There undoubtedly will be more lawsuits to come, as the FDIC has indicated on its website that as of August 4, 2011, it has authorized suits in connection with 30 failed institutions against 266 individuals for D&O liability with damage claims of at least $6.8 billion. With the Silverton Bank and FNB Nevada lawsuits, the FDIC has now filed suits in connection with eleven failed institutions against 77 individuals. Even just taking account of the lawsuits that have already been authorized, there are many more suits to come, and undoubtedly even more lawsuits will be authorized.
But with the back to back arrival of these two lawsuits in the space of two days, both involving banks the failed early on the the bank failure wave, there is a sense that the long lagtime associated with the FDIC's lawsuit filings may be over. For what it is worth, both of these new complaints both involve the same lawfirm on behalf of the FDIC, the Mullin Hoard & Brown law firm of Amarillo, Texas.
It is probably worth noting that the FDIC’s lawsuit is not the first to be filed against the former directors and officers of Silverton. As reflected here, the bank’s defunct parent company earlier this year filed suit against the bank’s former CEO and its former accountant and accounting firm, seeking about $65 million in damages.
Special thanks to the several readers who sent me copies of the Silverton complaint and related links. Special thanks also to the loyal reader who sent me a copy of the FNB Nevada lawsuit as well.
Number of Problem Banks Declines: According to the FDIC’s latest Quarterly Banking Profile, released on August 23, 2011 (refer here), the number of problem institutions during the second quarter of 2011 declined to 865, from 888 at the end of the first quarter of 2011. This reduction represents the first quarterly decline in the number of problem institutions in 19 quarters. (The FDIC identifies banks as problem institutions as those that are graded a 4 or a 5 on a 1-to-5 scale as a result of “financial, operational, or managerial weaknesses that threat their continued financial viability.” The FDIC does not release the names of the individual problem institutions.)
While the quarterly decline in the number of problem institutions is good news, the latest quarterly figure still represents a significant number and percentage of all banks. The 865 problem institutions represents about 11.5% of the 7513 of all reporting institutions. This is slightly lower than the 11.7% of all banks that were rated as problem institutions at the end of the first quarter.
With the continued weakness in the sector, the number of failed and troubled banks will continue to remain a concern for some time to come.
The FDIC’s August 23, 2011 press release regarding the latest Quarterly Banking Profile can be found here.
One of the many distinctive traits of the litigation that surrounded the S&L crisis in the late 80s and early 90s was the plethora of lawsuits between the FDIC (and other federal banking regulators), on the one hand, and the failed banks’ insurers, on the other hand, over the interpretation of the banks’ management liability insurance policies. Among the questions surrounding the current bank failure wave has been whether or not we will see a similar round of insurance coverage litigation. If a lawsuit filed last week in the Middle District of Alabama is any indication, the anticipated insurance coverage litigation may be on its way.
The coverage lawsuit arises out of the massive failure of Colonial Bancorp, which closed its doors on August 14, 2009. The bank’s holding company filed for bankruptcy on August 25, 2009. Among the factors contributing to Colonial’s failure was the criminal conspiracy relating to the failed mortgage lender, Taylor Bean & Whitaker. In April 2011, Lee Farkas, Taylor Bean’s ex-Chairman, was convicted of wire fraud and securities fraud.
Prior to Farkas’s conviction, two Colonial Bank employees pled guilty in connection with the Taylor Bean scheme. As reflected here, on March 2, 2011, Catherine Kissick, a former senior vice president of Colonial Bank and head of its Mortgage Warehouse Lending Division, pleaded guilty to conspiracy to commit bank, wire and securities fraud for participating in the Taylor Bean scheme. As reflected here, on March 16, 2011, Teresa Kelly, the bank’s Operations Supervisor and Collateral Analyst, pled guilty on similar charges.
The two bank employees allegedly caused the bank to purchase from Taylor Bean and hold $400 million in mortgage assets that had no value. The employees also allegedly engaged in fraudulent actions to cover up overdrafts of Taylor Bean at the bank. The employees are also alleged to have had the bank engage in the fictitious trades with Taylor Bean that had no value.
At the time of the bank’s failure, the bank carried three financial institution bonds. At or about the time that Colonial failed, the bank submitted notices of claim under the financial institutions bonds in connection with the activities and actions that ultimately were the topic of the criminal guilty pleas of the bank employees.
In a complaint filed on July 29 in the Southern District of Alabama (a copy of which can be found here), the FDIC as receiver for Colonial Bank, as well as the bankrupt bank holding company on its own behalf, filed an action against the bank’s bond insurer. Among other things, the complaint alleges that the losses caused by the misconduct “constitute recoverable losses under the Bonds up to the full aggregate limits of liability of the Bonds.”
The complaint states that the bond insurer “has neither accepted nor denied the Plaintiffs’ claims under the Bonds.” The complaint alleges that the insurer “has failed to investigate the claims and losses in a reasonable and appropriate manner.” After cataloging the back and forth between the FDIC and the insurer on their respective efforts to enter a confidentiality agreement, the complaint alleges that the insurer “has declined to enter into any of the proposed confidentiality agreements or offer appropriate confidentiality agreements of its own,” and “hence” the FDIC is unable to produce the confidential information that the insurer has requested. The complaint asserts a single claim for breach of contract.
Interestingly, the complaint does not specify whether or not the FDIC or the bankrupt holding company is entitled to recover under the bonds, but rather says that the amount of any recovery under the bonds is to be deposited in a bankruptcy court escrow account, where the issue of entitlement to the proceeds will be determined.
There are a number of arguably unusual features of this dispute. First, it is filed in connection with the failed bank’s financial institutions bonds, rather than in connection with the failed bank’s D&O insurance policy. To be sure, given the circumstances surrounding the bank employees’ guilty pleas, the implication of the bonds is hardly surprising. But the typical bank closure during the current round of bank failures will not implicate the failed bank’s financial institution bonds. The relevant insurance issues will more likely arise, if at all, under the failed bank’s D&O policy.
Another interesting thing about this dispute is that the parties are in coverage litigation even though the carrier has not even denied coverage. It looks as if the parties’ so-far unsuccessful attempts to hammer out a confidentiality agreement have gotten a little bit out of hand. It is mercifully uncommon for parties in similar circumstances to be unable to come up with a mutually acceptable confidentiality agreement. It may be that once the parties in this circumstance can finally manage to come up with a confidentiality agreement that this whole dispute will resolve itself without the need for further litigation (whether or not there was ever really any need for litigation in the first place.)
But the fact that the FDIC has not hesitated to file this suit in the first place certainly does evince a willingness to use the court to pursue its claims, as receiver, in connection with failed banks’ insurance policies. And while this case may not on its face present any significant coverage issues of more general significance, the likelihood is that as the FDIC presses claims for insurance recovery, that some of these claims will find their way into court with significant implications for questions of coverage under the applicable policies.
As I have said before, so many aspects of the current bank failure wave provide a feeling of déjà vu for those of us who lived through the S&L crisis. If the feeling is not necessarily one of nostalgia, it at least has a certain familiarity. Of course, it remains to be seen whether or not there will be any where near the amount of coverage litigation this time around. It just looks to me from this recent lawsuit that just like last time, the FDIC is not messing around, and it is not going to hesitate to use the courts to pursue claims against failed banks’ insurers.
Stanford and several other individuals have been criminally charged with financial fraud in connection with the collapse of the Stanford Financial Group. The criminal trial is set to commence in January 2011. Stanford and several of the other individuals are also defendants in an SEC enforcement action as well as numerous other civil proceedings.
Stanford Financial had $100 million in D&O insurance. The primary policy contains a money laundering exclusion that the insurers contend precludes coverage under the policies. The money laundering exclusion specifies that it does not apply "until such time as it is determined that the alleged act or acts did in fact occur."
In a January 26, 2010 opinion, Southern District of Texas Judge David Hittner entered a preliminary injunction prohibiting the insurers from "withholding payment" of defense expenses from four individuals (including Allan Stanford), as discussed here.
In a March 15, 2010 opinion (about which refer here), the Fifth Circuit reversed and remanded the case to the district court, concluding that the money laundering exclusion’s "in fact" wording required a judicial determination to establish whether or not the exclusion had been triggered, but also concluding that this determination can be made in a separate proceeding such as a coverage action.
Based upon the trial that began on Tuesday in Houston, the court will determine whether or not the money laundering exclusion has been triggered, and therefore whether the insurers have any obligations to pay the defendants’ attorneys fees or other amounts on the defendants’ behalf under the policies.
According to news reports, there were a number of interesting developments in the first day of trial.
First, the lawyer for Laura Pendergest-Holt, Stanford Financial’s former Chief Investment Officer, told the court that Pendergest-Holt had entered a settlement with the insurers. The details of the settlement were not disclosured.
Second, in response to a question from Judge Atlas as to where the policy’s unusual definition of "money laundering" had originated, the lawyer for the insurers told the court that the language had been in prior policies through several renewals, but the language originally "been brought to the contract negotiation …by Stanford’s insurance broker." The insurers’ lawyer said that the insurer did not plan to offer a witness on the origins of the language.
Judge Atlas commented: "All I can say, it’s turning out not to be such a bargain."
Third, the witnesses are unlikely to testify during the coverage trial, given the risks that would entail for the criminal case. Judge Atlas said she will not determine yet whether she will draw an adverse inference about the individuals’ guilt from the individuals’ decision not to testify during the coverage case.
Finally, the insurers revealed that to date the insurers had advanced over $15 million dollars to pay for attorneys’ fees on behalf of the individuals and other insured persons under the policy.
Think Your Commute is Bad?: According to an August 24, 2010 Wall Street Journal article, a 60-mile traffic jam near Beijing "could last until mid-September." Traffic has been backing up since earlier this month due to construction on the Beijing-Tibet highway. Traffic is now backed up "almost all the way to Inner Mongolia."
In a March 23, 2010 Summary Order (here), the Second Circuit affirmed the March 2, 2009 ruling of Southern District of New York Judge Gerald Lynch, in which he held that the excess insurers’ prior knowledge exclusion precluded coverage under their policies for claims brought against former Refco directors and officers.
As detailed in a prior post about Judge Lynch’s district court order (here), at the time that the Refco scandal emerged, Refco had $70 million of D&O insurance arranged in multiple layers. The primary and first level excess insurers advanced their entire combined $17.5 million limits of liability in payment of defense expenses. In a separate ruling not involved in this appeal, Judge Lynch ruled that the second level excess insurer also must advance its defense expense.
In his March 2, 2009 ruling (here), Judge Lynch granted summary judgment for the third and fourth level excess insurers, based on exclusions in those policies (not found in the underlying policies) precluding coverage for claims arising from any facts or circumstances of which "any insured" had knowledge at policy inception and that might reasonably be expected to give rise to the claim. (In a portion of his opinion not relevant to this appeal, Judge Lynch denied summary judgment as to the fifth level excess insurer.)
The critical question before Judge Lynch was whether the knowledge of the fraudulent scheme of Refco’s CEO Phillip Bennett could be imputed to the other directors and officers. These individual had sought to rely on so-called severability provisions in the primary policy, to which the excess policies were "follow form," and from which they sought to argue that the prior knowledge exclusion was not applicable to them. Their argument was that Bennett’s knowledge could not be imputed to them due to the non-imputation language in the primary policy’s severability provision.
Judge Lynch rejected their argument that the severability provision in the primary policy precluded the operation of the prior knowledge exclusion in the excess policy.
The Second Circuit’s March 23 Summary Order
In its March 23 Summary Order, the Second Circuit expressly adopted Judge Lynch’s "comprehensive and well-reasoned analysis." The Court quoted Judge Lynch’s language that "in the context of the [prior knowledge exclusion] the words ‘any insured’ unambiguously precludes coverage for innocent coinsureds."
The Second Circuit also expressly affirmed that because the exclusionary language in the excess policy "cannot be reconciled with the severability language provision of the underlying policy, the language in the excess policy controls." The Second Circuit also affirmed that the claims against the individuals come within the "arising out of" preamble of the exclusion.
As I detailed in my prior discussion of Judge Lynch’s opinion, this case illustrates the complicated ways that the various components of a single D&O insurance program can operate in unanticipated ways to produce unexpected results. The case also demonstrates the extent to which supposed "follow form" excess coverage is not always truly "follow form."
The outcome also underscores the importance of application and exclusion severability issues not just at the primary levels but all the way up the insurance tower.
My other ruminations about this outcome are set forth at length in my prior post about Judge Lynch’s opinion.
The Second Circuit’s Summary Order states on its face that it has no precedential effect. However, the practical effect of the Summary Order is the validation of Judge Lynch’s analysis, to which future litigants undoubtedly will refer.
It is probably worth noting that while Judge Lynch was a district court judge in March 2009 when he wrote his coverage opinion in the Refco case, by the time the Second Circuit got around to reviewing the case, Judge Lynch had become a member of the Second Circuit bench, where his new Circuit Court colleagues found his prior work as a district court judge to be "comprehensive and well reasoned." Perhaps the preservation of domestic tranquility around the courthouse water-cooler requires no less.
Special thanks to Neil McCarthy of Lawyer Links for providing me with a copy of the Second Circuit’s Summary Order.
Every now and then, I read a court opinion on a coverage issue, and though I can understand how the court reached its decision, I still find the outcome surprising and troubling. A January 19, 2010 per curiam opinion from the Connecticut Supreme Court (here) involving a coverage dispute under an Employment Practices Liability (EPL) policy presents a recent example of this kind of decision. The court’s analysis is internally logical, but I suspect the outcome would surprise most EPL policyholders and even many insurance practitioners. The decision may have important implications for the placement and administration of EPL insurance.
Background and the Connecticut Supreme Court’s Decision
National Waste Associates was purchased an EPL policy for the period February 15, 2007 to February 15, 2009. On May 12, 2007, a former employee brought a wrongful discharge action against National Waste. National Waste submitted the claim to its EPL carrier. The carrier refused to provide a defense or to indemnify the firm. National Waste filed a lawsuit seeking a judicial declaration of coverage.
The carrier took the position that coverage was precluded by the EPL policy’s prior or pending action exclusion. The exclusion provides that the policy does not provide coverage for any claim "based upon, arising out of, [etc.] … any fact, circumstance, situation, transaction, event or wrongful act underlying or alleged in any prior or pending civil, criminal or administrative or regulatory proceeding."
The carrier contended that the prior or pending action exclusion had been triggered by the proceedings the employee had brought in 2005 to obtain unemployment benefits. As later recited by the Connecticut Supreme Court in its review of the case, the former employee had claimed, both in pursuing unemployment benefits and in the later wrongful discharge action, that she had been wrongfully discharged after resisting National Waste’s alleged invasion of her privacy.
The trial court agreed with the carrier that the unemployment benefit proceedings clearly constituted prior "administrative proceedings" within the meaning of the policy and granted the carrier’s motion for summary judgment. National Waste appealed.
In its January 19 per curiam opinion, the Connecticut Supreme Court affirmed the trial court, adopting the trial court’s reasoning.
The court’s reasoning is straightforward and internally logical, particularly if the unemployment benefits proceeding is, as seems to be the case, fairly characterized as an "administrative proceeding" within the meaning of the policy.
But as noted in a January 21, 2010 memorandum about the ruling from the Murtha Cullina law firm entitled "Employment Practices Liability Insurance: Surprise Coverage Interpretation" (here), the outcome "no doubt shocked" the employer. The law firm memo identifies the sharp distinction between, for example the circumstances that might be involved had the former employee raised an EEOC charge of discrimination in a prior period, and the circumstances actually presented, with the former employee’s prior filing of proceedings for unemployment benefits.
As the law firm memo observes:
Unemployment compensation claims are not only very common, but they are typically handled very differently by employers. (For example, employers rarely if ever engage legal counsel to attend unemployment compensation hearings.) The standard for denying unemployment benefits is so high that employers often do not even contest the claims. Even if they do contest, most former employees who lose their jobs for any reason collect benefits. If fact, a claim for unemployment benefits is not even really a claim "against" the employer – it is a claim for state benefits that are funded by a tax on all employers. Moreover no EPLI policy provides coverage for unemployment claims.
In light of all of these practical circumstances, it would come as an unexpected and inexplicable revelation to most employers to learn that an unemployment benefits claims in one policy period could preclude coverage for an employment practices claim in another period. The implication is that the employer has to notify their EPL carrier of the unemployment benefits claim in order to preserve EPL coverage if the former employed later files an employment practices claim.
Most employers would be completely astonished to learn that their EPL carrier expects to be provided with notice of unemployment benefits proceedings. Indeed the revelation of this expectation is so unanticipated that it has the feel of a trap for the unwary.
The message for policyholders and their advisors hoping to avoid the trap seems to be that companies should provide carriers with notice of every single instance where an employee or former employee seeks unemployment benefits. However, given the frequency of these types of proceedings, I suspect strongly that if policyholders gave notice of every instance where an employee or former employee is seeking unemployment benefits, the carriers would quickly find themselves drowning in paper. I doubt the carriers would really want what would ensue.
And regardless of what the carriers may want or even expect, it is a serious question whether, as a practical matter, it is fair to penalize companies for failing to take actions that the most companies would have no idea are required of them.
Maybe I am being optimistic, but perhaps policyholder representative and the carriers can find a solution that will ensure that EPL insurers will not take the position that an action for employment benefits is not a "claim" or an "administrative action" within the meaning of the policy.
I recognize that some readers may take exception, perhaps strong exception, to my analysis. I invite readers to submit their views using the comment feature on this blog.
In a January 4, 2010 order (here), Southern District of Texas Judge Nancy Atlas held that an insurance broker’s Professional Liability Insurance insurer must defend the broker and one of its employees in connection with claims arising out of the Stanford Group fraud.
The Bowen Miclette & Britt insurance brokerage and one of its employees (Winter) have been named as defendants in several civil actions filed following the revelations of the Stanford Group fraud. The plaintiffs in the cases had deposited money in or invested in Certificates of Deposit issued by the Stanford International Bank (SIB).
The plaintiffs in the underlying lawsuits alleged that the brokerage provided the Stanford Group with "safety and soundness letters" that Stanford used in marketing. Among other things, the letters allegedly asserted that SIB was "insured by various Lloyd’s insurance policies" and that SIB had "qualified" for the Lloyd’s policies.
The defendants sought to have their insurer under the brokerage’s Professional Liability Insurance policy defend them in the underlying actions. The insurer denied coverage, and in July 2009, the insurer initiated an action against the brokerage and Winter in the Southern District of Texas, seeking a judicial declaration that there was no coverage under the policy for the claims. The defendants counterclaimed, alleging breach of contract and seeking a judicial declaration of coverage. The parties filed cross motions for summary judgment.
The January 4 Order
In her January 4 order, Judge Atlas denied the insurer’s summary judgment motion and granted the defendants’ motions, ruling that the allegations in the complaint gave rise to a duty for the insurer to defend. Judge Atlas’s ruling was without prejudice as to the duty to indemnify, the issues with respect to which she held were not yet justiciable because the underlying actions remain pending.
Judge Atlas first concluded that the allegations in the underlying cases about the defendants’ provisions of the "safety and soundness letters" were claims for "Professional Services" within the meaning of the policy.
The insurer argued that coverage under the policy nevertheless was precluded by the policy’s securities exclusion, which excluded coverage for any claim "based upon or arising out of any violation or alleged violation" of federal or securities laws. The insurer argued that the underlying complaints alleged securities violations and therefore the exclusion precluded coverage.
Judge Atlas agreed that the underlying complaints alleged violations of the securities laws, but noted that the complaints also "alternatively asserted negligence-based claims" that were not within the securities exclusion, and therefore the insurer owed the defendants a duty to defend all claims in the underlying lawsuit.
Winter had also sought to have the insurer defend him. Winter was an employee of the brokerage who allegedly had provided and signed the "safety and soundness" letters. The plaintiffs in the underlying case alleged that Winter had not disclosed that he was also a director of SIB.
Judge Atlas found that "in none of the three underlying lawsuits are there allegations against Winter in his capacity as a member of SIB’s Board or in any capacity other than an employee of BMB." She found that the allegations against him are based on professional services Winter provided in his capacity as a BMB employee and that the insurer owed him a duty to defend.
High-profile cases, particularly those charged with headline grabbing fraud allegations, can sometimes be difficult from an insurance perspective. Insurers may well feel that the kinds of things alleged are not the kinds of things for which they undertook to provide insurance. On the other hand, at the outset of a case, the allegations are as yet unproven. And the defendants dragged into a high profile cases need to be able to defend themselves.
There may or may not ultimately be indemnity coverage under the policy for the claims against BMB and Winter. But in the meantime, the defendants – who are insureds under the policy – face very serious allegations for which they would likely have trouble defending themselves if there were no insurance available. Unfortunately, in addition to having to defend themselves against very serious allegations in the underlying cases, they also had to deal with a lawsuit brought against them by the insurer from whom they were hoping to obtain a defense.
As Judge Atlas found, the complaint contained allegations that potentially come within the policy’s coverage, and so the insurer was obliged to provide a defense. If the defendants (and their insurer) are fortunate, their defense will succeed and the need to address the indemnity issues will never arise.
In a series of recent rulings in coverage litigation arising out of the 2007 collapse of Brookstreet Securities Corporation, a California-based securities broker-dealer, Central District of California Judge Cormac Carney addressed the claims of several claimants to the proceeds of a professional liability insurance policy that had insured the defunct company. Though the rulings are narrow and tied to the specific facts presented, the issues in dispute are likely to recur in claims arising from the subprime meltdown and accordingly the rulings may be of more general interest on that basis.
Brookstreet provided broker dealer services nationwide until mid-2008 when the company experienced a financial collapse. The company ceased operations in June 2007 and is now insolvent.
Brookstreet was insured under a Securities Broker Dealer Professional Liability Insurance Policy for the period November 8, 2006 to November 8, 2007. The policy provides coverage for claims made against Insured Persons for actual or alleged Wrongful Acts in the rendering of "Professional Services." The policy had limits of $3 million.
The policy is an express "claims made and reported" policy, requiring in order for coverage to apply both that the claim be made within the policy period and that notice of claim be given within thirty days and during the policy period.
The insurer brought an action for interpleader and posted a $3 million bond. The insurer then filed three separate motions for summary judgment as to certain separate groups of interpleader defendants, all of whom are in turn claimants against Brookstreet or certain of its former directors, officers or employees.
Judge Carney’s Rulings
In a three separate rulings, Judge Carney addressed each of the insurer’s summary judgment motions.
Claims Made/Late Notice Issues: First, in a November 20, 2009 opinion (here), Judge Carney addressed the insurer’s motion for summary judgment as to the defendant claimants who had not made their claim against Brookstreet prior to the policy’s expiration or with respect to whose claims Brookstreet had not provided notice of claim to the insurer prior to the policy’s expiration.
Judge Carney quickly granted the insurer’s motion as to the claimants whose claims were made after the policy’s expiration, or with respect to whose claims Brookstreet had not provided notice of claim to the insurer during the policy period.
The more interesting questions about notice sufficiency arose with respect to the claimants who had made their claims during the policy period and with respect to whose claims Brookstreet had provded notice of claim during the policy period, but with respect to whose claims Brookstreet had not provided notice within the 30-day period required under the policy.
Judge Carney, enforcing the policy’s notice requirements strictly, found that the insurer was entitled to summary judgment even as to this latter group of claimants. Judge Carney found that the 30-day notice requirement was a "condition precedent" to coverage and that "to force" the insurer to have to demonstrate prejudice in order for the notice provision to be enforced "would be to rewrite the insurance contract, and the Court is unwilling to take this step."
Derivative Claim Exclusion: The insurer had also moved for summary judgment as to those claimants whose claims arose out of or were based on transactions involving Collateralized Mortgage Obligations (CMO). The insurer relied upon a policy exclusion precluding coverage for claims "based upon, arising out of or attributable to the sale, attempted sale, or servicing of … any type of …derivative." Relying on this exclusion, the insurer argued that the CMOs are derivatives, and therefore the policy precluded coverage for claims relating to the CMOs.
In a November 20, 2009 ruling (here), Judge Carney concluded, based on extensive material provided by the insurer, that CMOs are "derivatives" within the meaning of the policy. Accordingly, he granted summary judgment as to those claimants whose claims were based on CMOs.
Interrelated Acts: The insurer had also moved for summary judgment as to a claimant who asserted that a Brookstreet employee had mismanaged her investments, through a pattern of "churning, making unauthorized trades, buying and selling high risk stocks, and failed to advise [her] of investment losses" during the period 1996 though June 2006.
The insurer argued that her claim arose out of an Interrelated Wrongful Act that first occurred prior to the policy’s September 10, 2002 retroactive date. The insurer further argued that the pre- and post-September 10, 2002 conduct constituted a single, non-covered Interrelated Wrongful Act. The claimant asserted that each of the improper acts was a separate Wrongful Act, and that each time Brookstreet failed to supervise its employee, it also committed a new and discrete Wrongful Act.
In a November 18, 2009 ruling (here), Judge Carney held that while he "does not discount the possibility that [the employee’s] actions may have constituted an Interrelated Wrongful Act …there are genuine issues of material fact as to whether the acts after September 10, 2002 were interrelated with those occurring before that date." Because a "reasonable jury could conclude" that each time the employee "made an unauthorized trade, churned [the claimant’s account] or bought and sold high risk stocks" each was a separate Wrongful Act.
Judge Carney’s rulings are interesting in and of themselves, but they are also interesting for what they suggest more generally.
First, his holding that the claims based on CMOs were precluded from coverage under the Brookstreet policy’s exclusion for derivatives claims is a reminder that the way insurance policies respond to many of the current claims based on complex financial instruments could involve a host of complicated insurance issues.
Although the exclusion that the CMO claims triggered in the Brookstreet case is peculiar to the specific type of insurance policy involved in that case, similar questions could arise under other policies in connection with other claims relating to complex investment securities and other financial instruments.
Many of the types of recurring claims asserted in the current litigation wave (e.g., the auction rate securities suits and the Madoff feeder fund lawsuits) present allegations of the type for which professional liability policies like that involved in the Brookstreet case were designed to respond. However, as the Brookstreet case shows, there potentially could be a host of complex coverage issues associated with many of these claims, depending on the facts alleged and the specific policy language involved.
Second, Judge Carey’s ruling on the interrelatedness issue is a reminder of how difficult interrelatedness questions can be. The term "interrelated" is neither defined in the typical policy nor is it self-defining. At a certain level of generalization, everything in the universe is interrelated, and at the same time, at another level, nothing is interrelated. What makes something interrelated for insurance coverage purposes can become quite situational and subjective, which leads many judges, like Judge Carney here, to want to leave interrelatedness questions to the jury.
Many of the cases in the subprime and credit crisis litigation wave present interrelatedness questions. Different complaints against the same or similar defendants in different policy periods raise the question whether one or several policies have been triggered. Judge Carney’s ruling in this case shows how difficult it may be for carriers seeking to rely on interrelatedness arguments. My own experience, consistent with Judge Carney’s ruling, is that courts tend to resolve interrelatedness questions in a way that maximizes the amount of insurance available.
Finally, Judge Carney’s rulings on the claims made and late notice issues are largely unremarkable, except as pertains to the question of the timeliness of notice for notices provided within the policy period but beyond the 30-day notice period. Judge Carney strictly enforced the policy’s 30-day notice requirement, and declined to even consider arguments based on the absence of prejudice.
Judge Carney’s literal enforcement of the notice requirement is is particularly noteworthy in that his ruling operated to preclude coverage for the claims of claimants where were in no way themselves involved with or responsible for the late provision of notice. ‘
In any event, Judge Carney’s rulings present an interesting case study. Special thanks to a loyal reader for providing me with copies of Judge Carney’s rulings.
On September 30, 2009, in a decision that will be widely discussed both because of the high profile figures involved as well as because of the outcome, Southern District of New York Judge Loretta A. Preska ruled (here) that the statute of limitations bars the action brought by the Milberg law firm’s professional liability insurers to rescind the policies they had issued to the firm.
During the period January 31, 2001 through January 31, 2004, the Milberg firm was insured under two professional liability insurance policies issued through the London insurance markets (the "Lead Policies") as well as under an Excess Policy.
In January 2002, Milberg and certain of its partners learned that they were the subject of a criminal investigation. The firm was served with investigative subpoenas. The law firm advised the insurers of the subpoenas and the investigation. The Lead Insurers provided defense expense funding in connection with the criminal investigation pursuant to an interim funding agreement.
The firm and several of its partners were indicted in May 2006. The firm provided a copy of the indictment to the insurers. During 2007 and 2008, four individual partners – Melvyn Weiss, David Bershad, William Lerach, and Steven Schulman – pleaded guilty to criminal charges for paying kickbacks to name plaintiffs in securities class action litigation. (Refer below for links regarding the guilty pleas.) On June 16, 2008, the prosecutor dropped the charges against the law firm itself under a non-prosecution agreement that required the firm to pay $75 million.
On August 26, 2009, the Lead Insurers filed an action seeking to rescind their policies, based on their allegation that they had been induced to provide the insurance by material misrepresentations in the policy application. The Excess Insurer intervened. The defendants moved to dismiss the action on the grounds that it is barred by the applicable statute of limitations.
The September 30, 2009 Decision
In granting the defendants’ motion to dismiss, Judge Preska rejected all of the Lead Insurers’ arguments that their action was not barred by the statute of limitations.
The Lead Insurers first argument was that the defendants should be "equitably estopped" from asserting the statute as a defense, because of the firm’s "emphatic denials" while the investigation was pending that the allegations had any basis. Judge Preska rejected this theory because the defendants failed to show or allege that they had reasonably relied on these denials of criminal guilt. Among other things, Judge Preska commented that:
This case … involves a contractual relationship between an insurer and an insured, both of who are sophisticated parties dealing at arm’s length. The London Insurers were not lulled into believing Milberg’s claims of innocence the same way a patient may be lulled into believing a doctor’s prognosis. And Plaintiffs do not contend that their contractual relationship with Milberg involved a fiduciary relationship such as that in a partnership, in which reliance on a party’s representations might be more justifiable. Therefore, the London insurers have failed to demonstrate that Defendants should be estopped from invoking the statute of limitations.
The court also rejected the Lead Insurers’ suggestion that the statute did not apply because the policy was void at its inception, holding that, notwithstanding the plaintiffs’ arguments, New York’s six year statute of limitations for fraud applied.
In that same vein, she rejected the plaintiffs’ argument that the running of the statute had been tolled because the insurers were providing a defense under a reservation of rights. Judge Preska noted that the plaintiffs "offer no authority holding that an insurer’s defense of its insured is inconsistent with investigating the validity of its contractual duty to defend." She went on to note that none of the cases on which the plaintiffs attempt to rely in support of their tolling argument "remotely suggest that an insurer’s duty to defend give it a special exception for the statute of limitations governing its own rescission claim."
Judge Preska further observed that "rather than awaiting the results of the government prosecution of Milberg, the London Insurers should have conducted their own inquiry into whether Milberg might have committed fraud in obtaining the London policies." The Court found that there was no record that the Lead Plaintiffs took any steps to determine whether the policies "were still valid."
Finally, Judge Preska rejected the Lead Insurers argument that their rescission claim was saved by the two-year discovery rule (that is, they argued that their action was brought within two years of the discovery of the fraud.) She found that because under New York law knowledge of a government investigation "clearly triggers a duty to inquire as to potential fraud," and because the Lead Insurers were aware of the government subpoenas soon after they were issued in 2002, they were put on notice of the alleged much longer than two years before they filed their action.
Judge Preska went commented further that "the most striking example of Plaintiffs’ willful ignorance of their potential rescission claim is their failure to have made any inquiry after Milberg was indicted." A "prudent insurer," she commented, "should have known in July 2006 that it may have a claim against Defendants for rescission." Yet, she noted, even then they undertook no inquiry, so that even if the two-year discover period runs from the time of the indictment, the rescission action "would still be time barred because Plaintiffs did not commence this action until August 2008."
If nothing else, Judge Preska’s opinion serves as a vivid illustration of a point I have made many times, which is that courts are hostile to rescission claims. Let it be said, courts don’t like them, even apparently when asserted against convicted criminals.
Because the decision is particularly dependent on New York case law with which I am insufficiently familiar, I am in no position to assess this decision on its legal merits. I will stipulate that this decision could well be completely unremarkable given the governing principles.
But even allowing for these legal principles, I have to say I find this outcome somewhat, well, uncomfortable. I know statutes of limitations exist to encourage diligence and to eliminate stale claims, and therefore must be enforced. There is no doubt that a great deal of time elapsed while these events transpired. And I am well aware the insurers must act promptly in order to assert rescission.
What I am unsure about is exactly what it is that the court thinks the insurers should have done. I can only imagine what might have happened if the insurers had tried to launch their own investigation while the criminal investigation and prosecutions were pending. The criminal defendants undoubtedly would have raised holy hell if the insurers had, say, tried to interview witness or obtain copies of documents. The defendants and their lawyers almost certainly would have accused the insurers of quadruple bad faith for even trying to take those actions. I imagine that the defense attorneys would have argued that the insurers were interfering with or even prejudicing the criminal defense.
I can envision compelling arguments that under these circumstances it was entirely appropriate that the carriers showed forbearance until after the guilty pleas had been entered before taking action – had they acted earlier, they might well have been accused of acting precipitously or worse.
Finally, I am not sure I am entirely comfortable with what this decision implies about what a carrier should do in similar circumstances in the future – perhaps New York law may require insurers who wish to protect their interests to do so, but would it really be a good thing for insurers to interject their own investigation at a time when one of their insureds is accused of criminal misconduct? That strikes me highly undesirable for all concerned.
This is a very high profile case and it obviously will attract a lot of attention and perhaps significant debate as well—indeed, I can well imagine some readers taking vociferous objection to observations here. I am very curious to know readers’ reactions, either to Judge Preska’s opinion or to my observations. I strongly encourage readers to post their thoughts using this blog’s "comments" function.
An October 1, 2009 Business Insurance article discussing the opinion can be found here.
Special thanks to a loyal reader for supplying me with a copy of the court’s September 30 opinion.
Memory Lane: For those interested readers, my original post about the Milberg indictment and its possible effect on securities class action lawsuit filings can be found here. My post about Bill Lerach’s guilty plea can be found here. My post about Mel Weiss’s indictment and Steve Schulman’s guilty plea can be found here. My post about David Bershad’s guilty plea agreement can be found here.
Could Madoff-related losses be insured under a homowners’ insurance policy? That is what is claimed in a class action complaint filed on August 19, 2009 in the Southern District of New York by Robert and Harlene Horowitz against their homeowners’ insurer and related entities. Their complaint (which can be found here) alleges that the insurer denied coverage under its policy for the more than $8 million that the Horowitzes claim to have lost in the Madoff scandal.
The plaintiffs claim that their homeowners’ policy contains a so-called Fraud SafeGuard provision, which insures against the "loss of money, securities or other property … resulting from fraud, embezzlement or forgery perpetrated against [policyholders] or [policyholders’] family member[s] during the Policy Period."
The Horowitzes claim that they had a family trust account, of which Robert Horowitz was trustee, with Bernard Madoff Investment Securities. They claim that their final balance on the BMIS account was over $8.5 million.
The complaint alleges that when they submitted their claim seeking payment for their claimed losses (which they assert is the full $8.5 million amount), the insurer denied coverage "on several grounds, all of which are erroneous."
The complaint is filed as a class action on behalf of all the policyholders under the defendants’ homeowners’ insurance policies with coverage for Fraud SafeGuard events and that lost money in the Madoff scheme.
The complaint asserts claims for breach of contract; breach of the implied covenant of good faith and fair dealing; and unjust enrichment. The class action seeks compensatory damages as well as "declaratory and injunctive relief to end the Defendants’ improper practices."
Though the complaint alleges that the defendants’ have denied coverage entirely for the plaintiffs’ claimed loss, a significant portion of the complaint is devoted to the plaintiffs’ contention that they are entitled to recover the full amount of their claimed $8.5 million loss, and not just the (unspecified) amount of the initial investment. They claim entitlement to the supposed investment gains that the plaintiffs’ believed they had earned on the BMIS account.
The plaintiffs argue that their loss is "the amount shown on their last account statement," and that their loss "cannot be erased by Defendants’ ad-hoc, after the fact definition of covered loss." The plaintiffs argue that in any event, they are at least entitled to implied interest on the initial investment as well as non-recoverable tax payments that had been made based on the Madoff statements.
The complaint also recites and refutes the applicability of the long list of policy exclusions on which the insurer relied in denying coverage, including, for example, that the policy does not cover loss caused by "the confiscation, destruction or seizure of property by any government or public entity or their authorized representative"; and that the policy does not cover "indirect loss resulting from any fraud guard event, including, but not limited to, an inability to realize income that would have been realized had there been no loss or damage to money, securities or other property."
It is interesting that the complaint was filed by the Milberg law firm, which may not be the first firm you think of when you think of insurance coverage litigation -- but on the other hand over the years, the firm has been in the forefront of class action litigation (albeit usually in the securities context), which may explain in part the fact that the complaint was filed as a class action.
When I noted recently (here) the arrival of the Madoff coverage litigation, I predicted that there would be a great deal more litigation to come. But I never expected that the first class action coverage lawsuit would be based on homeowners’ coverage. For that matter, I have to confess that I didn’t foresee the involvement of homeowners’ coverage at all. But if the Horowitzes get any traction with their lawsuit, I suspect that we could see a whole lot more litigation raising similar allegations. There may be many more claims to come under other kinds of first-party coverages, as well.
The one thing I know for sure is that earlier this year, when various commentators were putting out their estimates on the likely aggregate insurance losses from the Madoff scandal, they did not factor in the possibility of losses under homeowners’ insurance policies.
In any event, I have added the new class action complaint to my register of Madoff-related litigation, which can be accessed here. The insurance coverage litigation of which I am aware so far is listed in Table V of the Madoff lawsuit register.
I continue to believe that there will be a great deal more Madoff-related insurance coverage litigation, and as I become aware of any new cases I will add them to the register. I hope readers who become aware of Madoff-related insurance coverage lawsuits will please let me know (anonymity protected upon request, of course).
Special thanks to a loyal reader for bringing the Howowitz lawsuit to my attention.
Given the massive amount of litigation arising out of the Madoff scandal as well as the enormous sums of money involved it is perhaps inevitable that the scandal would also generate its own category of insurance coverage litigation. As the two cases described below demonstrate, the Madoff-related coverage litigation has now arrived. There undoubtedly will be much more to come in the weeks and months ahead.
The first of the two recently filed coverage complaints was filed on July 14, 2009 in Hennepin County (Minn.) District Court by Upsher-Smith Laboratories, a pharmaceutical company. A copy of the complaint can be found here. Since 1995, Upsher-Smith had invested all of its funds in its profit sharing plan with Bernard L. Madoff Securities LLC. As of December 2008, the company had invested $12 million in plan assets with Madoff. The company had also invested millions of its own with Madoff.
As a result of the plan losses, the U.S. Department of Labor launched an investigation, and by letter dated June 30, 2009, the DOL has demanded that the company "restore losses" to the plan, or the DOL may file a lawsuit.
Upsher-Smith filed a claim with its "Employee Benefits Plan Administrative Liability" insurer in connection with the plan losses and the DOL’s actions. The company has also filed an action with its crime insurer in connection with its own separate losses. Both carriers have denied coverage. In its July 14, 2009 complaint, Upsher-Smith seeks a judicial declaration of coverage under both policies, and also alleges breach of contract against both insurers.
The second of the two complaints was filed on July 15, 2009 in the Southern District of New York by Ann & Hope, Inc., which operates retail stores, as well as by an affiliated entity and affiliated persons. The complaint, which can be found here, was filed against the company’s crime insurers. The complaint alleges that on August 14, 2008, Madoff’s firm "caused $5 million to be transferred" from the affiliated company to Madoff’s account with JP Morgan. As a result of Madoff’s fraud, the funds have been lost. The company submitted a claim to its crime insurer, which has denied the claim. The complaint seeks a judicial declaration of coverage and also alleges breach of contract.
Merely because these complaints have been filed does not, of course, mean that they are meritorious. In that regard, I note that both complaints neglect to mention the specific grounds on which the respective carriers have denied coverage, an omission that may be telling. The stilted wording on the Ann & Hope complaint alleging that Madoff "caused the funds to be transferred" may suggest the kind of coverage problems that the companies seeking coverage under their crime policies for Madoff losses will have to solve.
There may well have been other Madoff-related insurance coverage litigation before these two cases, although I have been keeping track of all Madoff-related litigation fairly attentively and I have not seen any other coverage lawsuits before. The one thing I know for sure is that these lawsuits won’t be the last.
Madoff may be in prison for the next 150 years, but while he does his time outside the prison walls, the litigation his crimes have engendered will grind on for many years. I predict that the litigation will live on long after his obituary appears.
I have in any event added the two insurance coverage cases to my register of Madoff-related litigation, which can be accessed here. In recognition of the distinction that these two new coverage cases represent, I have created a new table on my litigation chart (Table V) for Madoff-related coverage litigation. I hope readers will help me to maintain the table by supplying me with copies of complaints of which they may become aware.
Special thanks to loyal reader Bill Sweeney for providing me with copies of the two coverage complaints.
Kevin M. LaCroix is an attorney and Executive Vice President, RT ProExec, a division of R-T Specialty, LLC. RT ProExec is an insurance intermediary focused exclusively on management liability issues. KevinMore...
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