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

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.

Background

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.”

Discussion

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.

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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.

Background

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.”

Discussion

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.

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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.

Background

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.

Discussion

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.

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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.

Discussion

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.”

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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.”

Discussion

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).

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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.)

Discussion

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.

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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.

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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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