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

The question of insurance coverage for the attorneys’ fees of Allen Stanford and his co-defendants is at issue in a three-day bench trial before Southern District of Texas Judge Nancy Atlas that began on Tuesday, August 23, 2010 in Houston.

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."

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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.

Background

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.

Discussion

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.

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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.

Discussion

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.

This may be one of those instances where the professional liability industry needs to come together to craft a solution to prevent an outcome that no one could possibly really want. (I have in mind the recent sequence of events where the D&O industry, in order to avert the consequences of an unexpected coverage decision, quickly took steps to try to eliminate the possibility of a carrier arguing that a Section 11 settlement did not represent covered "Loss.)

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.

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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.

Background

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.

Discussion

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.

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

Background

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

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

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

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

Judge Carney’s Rulings

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

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

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

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

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

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

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

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

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

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

Discussion

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

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

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

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

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

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

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

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

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

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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.

Background

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."

Discussion

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.

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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.

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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.

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