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

In recent posts (here and here), I have discussed the issues surrounding coverage under D&O insurance policies for investigative costs and special litigation committee expenses. In response to these posts, readers Jeff Kiburtz and Cindy Forman of the Santa Monica law firm of Shapiro Rodarte & Forman have submitted the following guest blog post. This guest post of course reflects the views of the post’s authors, and not necessarily those of the author of The D&O Diary. Cindy and Jeff's guest post is as follows:  

Having recently ended an unusual week straight of rain in normally sunny Los Angeles, the saying "when it rains it pours" comes to mind. This phrase aptly describes the situation in which many companies find themselves when revelations of accounting irregularities or other alleged misconduct surface – first there is a story in the press, then a letter indicating the SEC opened an informal investigation, next a DOJ subpoena, and, sometime during this period, the company’s stock drops and a shareholder makes a demand for an investigation or forgoes the demand and files a derivative suit.

The response to this downpour is immediate and expensive. Typically, at least three sets of law firms are retained – one to handle the government investigations and private litigation, a second to conduct an internal investigation and report to a special committee established by the company, and a third, which usually consists of several different firms, to defend the implicated directors and officers.

Recognizing the potential to spend large amounts of money very quickly, in-house counsel and the company’s outside lawyers move to create a division of labor between the various firms to coordinate the overall effort. Central projects such as the review, coding and scanning for privilege of all of the documents potentially relevant to the underlying issue are assigned to a specific firm, frequently the internal investigation counsel. Work specific or unique to the various groups is, however, done by the respective group’s own counsel.

Although each firm represents the unique interests of their clients, and potential or actual conflicts are therefore implicit, in many circumstances the various interests are largely aligned and the attorneys can and do work together for the mutual benefit of all. If, for example, the company needs to respond to a DOJ document subpoena, there is no reason their theoretically diverging interests should prevent the company’s defense counsel from tapping into the document review work done by the internal investigation counsel to locate responsive documents.

The single greatest beneficiary of this collaboration is the company, which in many circumstances is required to pay the bill for all of the various lawyers. We would think that, by extension, the company’s D&O insurers would also see and appreciate the extent to which collaboration between the various groups reduces the overall legal spend. It seems, however, that many D&O insurers are quite restrained in their enthusiasm, often declining coverage for various categories of fees incurred by the company under numerous theories. One fee category that is almost uniformly declined is fees incurred by internal investigation counsel, which, perhaps coincidentally, also happens to be the largest single line-item in many situations.

When declining coverage for internal investigation fees, insurers often argue that because the definition of "Claim" does not specifically reference internal investigations, fees incurred by internal investigation counsel were not incurred "in connection with a Claim." Insurers also argue that the internal investigation counsel represents only the special committee, which typically is not one of the enumerated categories of "Insureds" under most D&O policies. A related argument is that internal investigation counsel is supposed to be neutral and objective, such that their work cannot be described as defensive in nature and, therefore, cannot be considered "defense costs."

Most policyholders regard these arguments as formalistic and compartmentalized, divorced from the business realities of these "when it rains it pours" situations. For one, the carriers do not give adequate consideration to the fact that much of the internal investigation work (e.g., construction of an electronic document database and obtaining witness statements) is relevant and necessary to defending any securities claim or government investigation, and would need to be performed even in the absence of any internal investigation. In this sense, the insurer’s objection is one of form not substance, as the nature of the substantive work is less relevant to the insurer than the designation of the firm who handled that work (e.g., document review conducted by defense counsel is admittedly covered, but that same work is allegedly not covered merely because it was performed by internal investigation counsel).

Further, the insurers’ arguments tend to disregard the direct and obvious connection between the allegations of and investigation into potential wrongdoing and the coordinated effort taken and paid for by the company to investigate and respond in an appropriate manner. When the allegations surface, all of the attorneys involved, whether they represent the company, the special committee or the individual insureds. need to review documents and interview witnesses to determine the relevant underlying facts that impact their respective clients’ interests. It often is not until much later, if at all, that facts surface which demonstrate that the various parties’ interests are in fact adverse. That the information gained during the earlier investigation phases might be used by the special committee in a manner inconsistent with coverage (e.g., advising the board to pursue litigation against directors and officers) does not justify a wholesale declination of all fees incurred by the special committee.

A few of these issues came up in the recent MBIA v. Federal Ins. Co. coverage action Kevin has addressed (here and here), where the court seemed not to have been overly warm to the legal principles underlying the insurer’s arguments.

Federal argued that the firm which handled the internal investigation, Dickstein Shapiro, represented only the special committee, not the company or any of the other insureds. Although the court dismissed this argument on a factual basis (finding that Dickstein made an appearance on behalf of the company in the securities litigation), it also noted that, independent of this fact, the special committee was comprised of members of the board of directors who were expressly charged with acting in the best interest of the company and who "could readily reach independent decisions without being independent of [the company]." While this portion of the opinion could have been more clear, the court’s decision cuts against both the notion that special committees are necessarily separate "entities" from the company and that their required independence precludes characterizing as "defense costs" the work done on their behalf.

Another aspect of the court’s decision in MBIA is also worth noting. Insurers frequently argue that internal investigation counsel’s work was not performed "in connection with a Claim," but rather was performed "in connection with" something other than a "Claim," e.g., an internal investigation. This argument makes relevant the causal nexus implied by the "in connection with" language. Policyholders often argue that the implied nexus in this non-exclusionary term is very broad, something akin to an incidental or minimal causal connection; for example, the fees are covered if they bear some reasonable relationship to a covered claim. In our experience, insurers appear reluctant to characterize the allegedly required nexus, but by implication seem to suggest something like predominant causation; for example, the fees are covered only if the predominant reason for doing the work was to defend against the covered claim. While it does not appear that the parties in the MBIA case briefed this issue, by finding coverage for the internal investigation fees related to the derivative suits the court arguably recognized that "in connection with" implies only a minimal causal connection in this context.

The insurance bar is likely concerned by the MBIA decision, as it could have widespread implications. It will be interesting to see whether Federal seeks appellate review or whether insurers in the future will simply seek to downplay the significance of a district court decision and attempt to confine it to the facts before the court. 

The D&O Diary would like to thank Cindy and Jeff again for their submission of this guest post. The D&O Diary accepts appropriate guest posts from responsible commentators on topics relevant to this blog. My goal in hosting guest posts is to encourage discussion of important topics and to facilitate the exchange of contrasting points of view. Readers who are interested in submitting guest posts should feel free to let me know using the "Contact" function on this blog. 

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The individual defendants in the various Stanford Financial-related SEC enforcement and criminal proceedings have been engaged in a long-running and procedurally complicated battle over whether the firm’s D&O insurers must advance the individuals defense expenses. In a sweeping January 26, 2010 opinion (here), Southern District of Texas Judge David Hittner rejected the grounds on which the insurers sought to avoid coverage and ruled that the insurers must advance the individuals’ defense costs.

Background and the January 26 Opinion

The defense fee dispute has a complex procedural history but for purposes of the January 26 opinion the critical fact is that on November 16, 2009, the insurers sent the individuals letters "retroactively declining to extend coverage for costs." The insurers contended that coverage was precluded by the Policy’s "money laundering" exclusion. The exclusion precludes coverage for loss "arising directly or indirectly as a result of or in connection with any act or acts (or alleged act or acts) of Money Laundering," as that term is defined in the policy.

In his opinion, Judge Hittner noted that the carrier’s were not seeking to avoid coverage based on the exclusion precluding coverage for fraud or criminal misconduct, because that exclusion has a requirement of an "adjudication" that the precluded conduct had occurred. The money laundering exclusion has no "adjudication" requirement, leaving, the insurers’ argued, the determination that money laundering has in fact occurred, to the insurers.

Judge Hittner also noted parenthetically that the insurers urged this position even though only one of the twenty-one counts in the criminal action alleges money laundering or conspiracy to commit money laundering. (The insurers argued that the policy’s definition of money laundering was broad enough to encompass all of the allegations.)

The plaintiffs first opposed the insurers’ position based on the "eight corners" rule, arguing under Texas law that in determining an insurer’s defense obligations, a court may not consider anything beyond the four corners of the policy and the four corners of the complaint. Judge Hittner found that despite the insurers’ arguments to the contrary, the Supreme Court of Texas "never has recognized an exception to the eight corners rule."

Judge Hittner was in any event strongly against a broader view of what a court properly might consider in determining the insurers’ obligations.

If a contemporaneous duty to advance or reimburse defense costs were judge on an "actual facts" basis, an insurer’s contractual obligation to pay defense costs could change on a daily basis as additional "facts" are developed. Essentially, coverage that directors and officers relied upon and expected when the Policies were purchased on their behalf could be withdrawn at the insurer’s whim. If, as Underwriters suggest, the Policies afford Underwriters absolute discretion to withhold payments whenever charges of intentional dishonesty are leveled against directors and officers, then insurers will be able to withhold payment in virtually every case at their discretion. That would leave directors and officers in an extremely vulnerable postion , as any allegation of dishonesty, not matter how groundless, could bring financial ruin on a director or officer. Essentially an insurer could act as judge and jury and convict its own insureds, thus avoiding any further financial responsibility for the insureds’ defense. This simply cannot be the case. (Citations omitted.)

The court found in applying the eight corners rule that the allegations were insufficient to establish that the precluded conduct had occurred. The insurers nevertheless sought to argue that the individuals refusal to testify in support of the application for a preliminary injunction is proof enough that the allegations against the individuals are true. The insurers sought to argue that the refusal to testify supported an inference that money laundering did in fact occur.

Judge Hittner held that the "given the magnitude, complexity and nature of the charges," he declined to draw the inference, and that in any event, because of the eight corners rule, the insurers’ reliance on the supposed inference from the individuals refusal to testify is "misplaced."

Judge Hittner, applying the standard required for a preliminary injunction motions ruled that though the money laundering exclusion does not require a judicial determination to apply, the exclusion’s requirements "also may mean much more than an insurer’s own determination." He said that he need not decide what level of factual determination must be made, and instead ruled only that plaintiffs have a substantial likelihood of succeeding on the merits at trial, satisfying the standard for awarding preliminary injunctive relief.

The court, in further consideration of the preliminary injunction standard, noted that the plaintiffs would suffer "irreparable harm" if the relief they sought was withheld. He noted that it is "unmistakable and cannot be seriously disputed" that the harm the individuals will suffer is "real, immediate and irreparable." He rejected the insurers contrary position that, he said, would "essentially require [the individuals] to prove their innocence." Judge Hittner commented that
 

Underwriters’ position is absurd because these circumstances are precisely why corporations procure D&O insurance on behalf of their directors and officers. Indeed, it would contravene the very purpose of the Policies – as well as the policy language itself – to require Plaintiffs to prove their innocence before being entitled to funds for their defense.

Judge Hittner found the harm to the insurers from granting the preliminary injunction was relatively slight and that public interest also weighed in favor of granting the preliminary injunction. He finally held that the individuals did not have to post a bond.

Discussion

Given the nature of the allegations against the individuals and the notoriety of the circumstances, as well as the number of people who lost money as a result of the collapse of Stanford Financial, the tone and temperature of Judge Hittner’s words are a little surprising. If nothing else is clear, Judge Hittner was certain that individuals needed to be able to defend themselves, and the insurers were obliged to provide the defense. The depth of Judge Hittner’s discussion of these defense cost issues are such that his words may prove useful for other individuals who are seeking to have their defense expenses paid under their policies.

You do get the sense that Judge Hittner ducked the hard issue – that is, if the money laundering exclusion, unlike the fraud exclusion, doesn’t have an "adjudication" requirement, then an adjudication can’t be required, so what is sufficient? Given Judge Hittner’s certainty that the eight corner rule is absolute under Texas law, there might be no way to meet the requirement. It does make you wonder whether it matters from a practical perspective whether or not there is an "adjudication" requirement.

Even though the usefulness of Judge Hittner’s determinations for others seeking insurance coverage arguably might be limited to those jurisdictions that also absolutely enforce the eight corners rule, the breadth of his pronouncements about the limitations on insurers’ ability to make preclusive coverage determinations virtually guarantees that his phrases will appear in the legal briefs of other individuals who are seeking defense cost coverage. His unwillingness to allow the individuals’ refusal to testify on their own behalf in the preliminary injunction proceeding may also prove helpful to other policyholders.

Because of the tone of Judge Hittner’s rhetoric and the high profile nature of the case, I suspect there may be some strong views about this decision. I invite readers who have thoughts about this decision to add their views to this post using the blog’s comments feature.

A January 26, 2010 Bloomberg article about Judge Hittner’s ruling can be found here.

Special thanks to Bill Schreiner of the Zuckerman Spaeder law firm for providing me with a copy of the decision.

Vivendi Watch: The Vivendi securities class action case went to the jury on January 11, 2010, but still no verdict. The parties are anxiously awaiting the verdict and in the meantime debating what the length of the jury deliberations may mean, according to a January 26, 2010 article by Andrew Longstreth on AmLaw Litigation Daily (here). The article also reports that almost regardless of the verdict, there will likely be an appeal, if for no reason that because of the potential jurisdictional implications of the National Australia Bank case now pending before the Supreme Court. Stay tuned (to the second power, apparently).

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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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Among perennial D&O insurance issues are questions whether policy coverage is available for defense expenses incurred in connection with investigative costs, subpoenas and the costs associated with special litigation committees. A December 30, 2009 decision in the coverage lawsuit brought by MBIA against its D&O insurers considered all of these recurring issues, and reached some interesting decisions.

Background

For the policy period February 15, 2004 to August 15, 2005, MBIA carried $30 million of D&O insurance, arranged in a primary layer of $15 million and an additional $15 million layer of excess insurance.

In 2001, prior to the policy period, the SEC had issued an Order Directing Private Investigation in connection with certain of MBIA’s loss mitigation insurance products. In November and December 2004, the SEC issues subpoenas to MBIA concerning "nontraditional products." The New York Attorney General also issued subpoenas in November and December 2003 regarding nontraditional products. Both the SEC and the NYAG issues additional subpoenas in March 2005. In spring 2005, MBIA, because of concerns about the cumulative impact in the marketplace, asked regulators to forbear from issuing additional subpoenas and agreed to comply voluntarily with informal document requests.

In October 2005, MBIA submitted an offer of settlement to the SEC in connection with certain specific transactions. In the offer of settlement, MBIA undertook to retain an independent consultant to review MBIA’s accounting for the transactions. In January 2007, the SEC entered a Cease and Desist Order and the NYAG entered an Assurance of Discontinuance, both of which documents largely incorporated the company’s prior offer of settlement. Thereafter the company hired a consultant to undertake the proposed review.

In additional to these regulatory investigations, the company, as nominal defendant, was also sued in two derivative lawsuits, as a result of which the company organized a Special Litigation Committee. An outside law firm "represented the SLC," and according to MBIA, also "represented MBIA through its representation of the SLC." The derivative lawsuits were later dismissed.

MBIA claimed that it has spent $29.5 million in defending or responding to the regulatory investigations and the follow-on litigation. The primary insurer had reimbursed $6.4 million but disputed that it was obliged to reimburse other amount incurred. MBIA filed an action against the two insurers alleging breach of contract and seeking a judicial declaration that the insurers were obligated to reimburse the company for legal fees and other costs associated with the regulatory investigations and the derivative actions. The parties filed cross motions for summary judgment.

The December 30 Ruling

The defendant insurance companies had disputed coverage for the investigative items, in part of the grounds that the matters in connection with which the defense costs were incurred were not "securities claims" within the meaning of the primary policy.

The primary policy defined a "securities claim as "a formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document" that "in whole or in part, is based upon, arises from or is in consequence of the purchase or sale of, or offer to purchase or sell, any securities issued by" the company.

In his December 30 Order, Southern District of New York Judge Richard M. Berman reviewed each category of defense expense separately.

Judge Berman first considered the defendants’ arguments that there was no coverage for fees incurred in responding to the NYAG’s subpoenas because the subpoenas were not a proceeding commenced by the filing of an "order or similar document." Judge Berman first found that the subpoena, which literally "commanded" compliance, was an "order" within the "common understanding" of "an ordinary businessman." He found further than even if it were not an "order" it was "sufficiently a ‘similar document’ that triggers coverage under the policy."

Judge Berman then considered the certain aspects of the SEC’s investigation, which the defendant insurers contended pertained to "traditional reinsurance" rather loss mitigation products. The defendants argued that the SEC’s 2001 Order Directing Private Investigation pertained only to the investigation of loss mitigation products, and so the SEC’s investigation of traditional reinsurance transactions was not pursuant to an "order."

Judge Berman rejected this argument among other reasons on the grounds that "Defendants have offered no persuasive evidence to support their argument that the SEC ran a series of concurrent investigations."

The defendant insurers also argued that the NYAG’s oral requests for documents pertaining to traditional reinsurance transactions were not pursuant to an "order." Judge Berman found that "defendants point to no persuasive evidence to suggest that the NYAG’s request for documents" relating to the reinsurance transactions "were part of separate investigations."

MBIA had also sought reimbursement for its costs incurred in connection with the independent consultant. Judge Berman found that there was no coverage under the policy for the costs associated with the independent consultant because MBIA "did not permit Defendants to effectively associate with it" because it did not inform the insurers about the independent consultant (and arguably did not get the insurers consent to agree to the independent consultant) "until at least ten months after it had committed to retaining" the independent consultant.

Finally, Judge Berman found that there was coverage under the policy for the fees incurred by counsel for the special litigation committee. MBIA had argued that the law firm had represented MBIA through its representation of the SLC. The carriers argued that the SLC was, by definition, independent, and therefore its counsel could not have represented the company.

In rejecting the insurers’ arguments, Judge Berman found that the SLC’s counsel had appeared as counsel for MBIA in the derivative actions and had filed pleading in the actions on behalf of MBIA. But even assuming that the law firm represented only the SLC, Judge Berman found there would still be coverage, because the SLC was composed of individual members of MBIA’s board who were acting pursuant to delegated authority from the board. Judge Berman noted that "the SLC could readily reach independent decisions without being independent of [MBIA]."

Discussion

The questions whether the kinds of defense fees in dispute in this case will be covered is often going to be a factor both of the policy language at issue and the specific facts involved. To a certain extent, Judge Berman’s decision may simply be a reflection with a very distinctive set of facts. In particular, it is a rather unusual feature of this set of circumstances that all of the disputed legal fees were incurred after the SEC had entered a formal order of investigation. Given that, it seems as if the only remaining dispute was whether or not the other investigative actions of the regulators were or were not related to the Order.

Judge Berman’s finding of coverage for the SLC legal counsel’s expense may also be a reflection of the fact that the law firm also entered an appearance on the company’s behalf in the derivative suit. These circumstances are not always present in connection with disputes over SLC’s counsel’s fees (although that fact certainly does not answer the question of the SLC’s counsel’s fees incurred prior to making an appearance in the derivative suit.)

But even though the decision may be a reflection of the particular facts involved, Judge Berman’s ruling nevertheless is significant as an example where a court found coverage for fees incurred with regulatory subpoenas, oral document requests, and special litigation counsel fees.

In particular, Judge Berman’s finding that, at least under these circumstances, the policy covered oral document requests and that the policy would have covered the SLC counsel’s defense even if it had not been counsel of record for the company in the derivative suit are particularly noteworthy.

Judge Berman’s finding the policy covered the SLC counsel’s expense because the SLC, though independent, was a committee of the Board operating pursuant to the Board’s delegated authority, is particularly noteworthy, and may represent a basis on which other insureds may seek to argue for coverage for SLC counsel fees.

This interesting case combines a number of frequently disputed issues. I expect that many readers may have reactions to this ruling and I would be very interested in hearing readers’ thoughts.

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Stanford Financial Group’s D&O insurer may advance the individual directors’ and officers’ defense expenses without violating the court’s receivership order, according to an October 9, 2009 ruling by Northern District of Texas Judge David Godbey. A copy of Judge Godbey’s ruling can be found here.

As detailed in a prior post (here), the insurer had been prepared to begin advancing defense expenses of Stanford Group’s former CFO, Laura Pendergest-Holt, subject to a reservation of its rights to later deny coverage under the policy if circumstances should warrant. However, before the insurer began advancing these amounts, the Stanford group receiver had notified the receiver that if the insurer advanced Pendergest-Holt’s defense expenses, the receiver would seek to have the insurer held in contempt of court for violating the court’s receivership and asset freeze orders.

The receiver asserted that the proceeds of the D&O insurance policies are "receivership assets" within the meaning of Judge Godbey’s prior receivership and asset freeze orders. The receiver also argued that his right to the proceeds "supersedes" the rights of insureds under the policy.

Pendergest-Holt filed a motion in the SEC enforcement proceeding (here) seeking a judicial clarification that the receivership order does not apply to the D&O policy proceeds, and alternatively seeking authorization for the disbursement of the proceeds for payment of her defense expense.

The insurer itself had also inquired of the court whether it could advance the defense expenses without "running afoul" of the receivership order. However, the insurer, which has separately filed an action seeking a judicial declaration that the Stanford receivership is not entitled to payment of claims as a result of the operation of policy exclusions, did not request the court in the SEC enforcement proceeding to decide whether or to what extent any insured is entitled to coverage—it sought only to determine whether the receivership order barred it from advancing the individuals’ defense fees.

In his October 9 ruling, Judge Godbey concluded that he did not need to determine whether or not the proceeds were receivership assets, because he concluded that he would exercise "equitable discretion" to permit the payment of defense costs "even if the proceeds were part of the receivership estate."

In deciding to exercise his discretion to allow the proceeds to be advanced for defense expenses, he noted that "there is no argument that the insurance proceeds are potentially tainted by fraud" and therefore "the Court has not duty to preserve them as such." As for the possibility that the insurance premiums might have been paid with "stolen money," he noted that while this might be "unjust and regrettable," that fact "would not entitle victims to proceeds of policies intended to pay defense costs."

With respect to the receiver’s argument that allowing policy proceeds to fund the individuals’ defense expense would "decrease the coverage dollars eventually available for distribution," Judge Godbey found that "the possibility that the D&O proceeds might one day be paid into the receivership does not justify denying the directors’ and officers’ claims." The judge noted that the receiver "has not yet tendered any claims against the Stanford entities to [the insurer] for a defense," noting further that even if it had, "it is not at all clear" that the insurer would ever pay a claim into the receivership, owing to the insurer’s policy defenses.

Finally, Judge Godbey found that the "interests of fairness" justify allowing the individuals to access the insurance proceeds. The receivership’s potential claims are "speculative" while the individuals "expected that D&O proceeds would afford a defense" and the "potential harm to them if denied is not speculative but real and immediate: they might be unable to defense themselves."

Judge Godbey emphasized that in his ruling that his prior orders the insurer from disbursing policy proceeds to fund the individuals’ defense, he was not holding that any defendant "is entitled to have its defense costs paid by D&O proceeds." Moreover, Judge Godbey emphasized that his October 9 ruling does not authorize the insurer "to pay any claims other than defense costs."

Though Judge Godbey ruled only on Pendergest-Holt’s motion, his ruling expressly "extends to any covered officer or director whose claim is approved" by the insurer. Judge Godbey’s ruling seemingly applies to R. Allen Stanford himself, at least to the extent that the ruling represents a determination that the court’s prior receivership orders are no bar to the insurer advancing defense costs.

Whether the insurer will in fact advance Allen Stanford’s defense expenses may be yet to be determined, notwithstanding the October 9 ruling that the receivership order is no bar. An October 9, 2009 Bloomberg article (here) presumes that as a result of Judge Godbey’s ruling, Stanford is now entitled to have his attorneys’ fees advanced. Indeed, absent a judicial "determination" that Stanford in fact engaged in excluded misconduct, the basis on which the insurer might withhold advancement of Stanford’s defense expenses is not immediately apparent, notwithstanding the seriousness of the allegations against him.

The problem for everyone involved is the sheer number of persons who will seek to have their defense fees paid by the insurance and the extent of the collective defense expense. According to the Bloomberg article, as many as 60 Stanford officials are seeking to use the D&O insurance proceeds to pay their legal bills. Moreover, many of these individuals are involved in numerous civil and criminal proceedings.

The total amount of D&O insurance available is not entirely clear from the published reports. The Bloomberg article variously reports that the total insurance limits are "as much as $50 million" and "as much as $90 million" – kind of a big swing on a rather important detail. But the potential for defense expenses in catastrophic claims to substantial erode or even exhaust insurance programs of a similar magnitude has already been demonstrated in other claims (refer for example here).

Given the seriousness of the allegations and the multiplicity of proceeding involved, the various individuals’ collective defense expenses could quickly erode the available limits, particularly if, as seems possible, Stanford himself accesses the policy proceeds for his defense expenses.

It is worth noting that Judge Godbey exercised his discretion to allow the proceeds to be advanced toward the defense expenses, notwithstanding the Stanford entities’ potential claims, even though this policy reportedly lacked a "priority of payments" provision, which would have given the individual defendants priority to the policy proceeds over the entity, as a matter of policy language. As discussed in an October 4, 2009 Business Insurance article (here), this type of provision is now standard in most D&O insurance policies, and might have helped sort out this dispute, although in the end the outcome apparently would have been no different.

Special thanks to William Schreiner of the Zuckerman Spaeder law firm for providing me with a copy of Judge Godbey’s October 9 ruling.

No D&O Policy Coverage Where Claim Made Only Against the Company: In an October 8, 2009 opinion (here), the First Circuit held that a D&O insurance policy does not cover the settlement of a disability discrimination claim that did not name any individual directors and officers as defendants.

The Medical Mutual Insurance Company of Maine had been sued in an administrative proceeding by a former company executive who claimed that the company had discriminated against him due to his stroke-related disability. The administrative proceeding resulted in a "right to sue" letter, pursuant to which the former executive initiated a federal court discrimination lawsuit. Both the administrative complaint and the federal complaint named only the company itself as a defendant.

The company settled the lawsuit and sought coverage under the D&O insurance policy for $325,000 of the settlement amount. The D&O insurer denied coverage under its policy, arguing that because there had been no claim made against an individual director or officer, there was no coverage for the settlement under the policy’s "corporate reimbursement" coverage. (The opinion explains in footnote 3 that while the policy also separately provided "entity coverage" for "securities claims," the discrimination complaint was not a securities claim and accordingly the policy’s separate entity coverage provisions were not implicated.)

In an October 8 opinion written by Judge Bruce Selya, the First Circuit held that the company’s argument that the policy’s coverage extended to claims in which directors and officers were not named as defendants "would if accepted transmogrify D&O policies into comprehensive corporate liability policies," and that "such a transmogrification is contrary to both the letter and the spirit of the D&O policy at issue."

The company had argued that the Policy’s claims made requirement had been satisfied because the underlying discrimination complaint consisted "largely of allegations of misconduct on the part of the directors and officers." The First Circuit held that "no matter what conduct the complaint describes, it is not a claim ‘made against’ any of the directors and officers."

The court went on to note that the policy’s separate requirements of both allegations of wrongful acts and for claims against insured persons "are complementary requirements and allegations of wrongful acts, without more, do not satisfy both."

The First Circuit’s opinion is arguably unremarkable, as D&O policies clearly and separately require both allegations of wrongful acts and claims to be made against insured persons.

The only puzzling thing to me about this case is why there was a D&O insurance dispute at all. The more natural place for the company to have looked for coverage for a claim like this is an Employment Practices Liability (EPL) insurance policy. EPL policies are designed to provide coverage for employment-related discrimination claims and generally provide coverage for claims against the insured organization.

Because I was curious, I ran down the parties’ appellate briefs on PACER. As it turns out, and as might have been predicted, the insured company did indeed also submit this claim to its EPL insurer.

As reflected in the D&O insurer’s appellate brief (here, at pages 4-6), not only did the EPL insurer provide the company with a defense for the underlying claim but it also paid $225,000 toward a total settlement amount of $500,000. The remaining $325,000 portion of the settlement amount for which the company sought coverage under the D&O policy represented the amount the company paid in resolution of the former executive’s unpaid contractual severance and benefits, for which the EPL carrier denied coverage under its policy.

So – that explains why this company was trying to stick what is rather obviously an EPL claim into the D&O policy, because there was a portion of the underlying EPL claim settlement for which the EPL policy did not provide coverage.

In any event, congratulations to my friend and former colleague Leslie Ahari, who represented the insurer in this action.

An October 12, 2009 Law.com article discussing the opinion can be found here. Special thanks to alert reader Marty Fox for providing me with a link to the Law.com article.

The Transmogrifier: For reasons unrelated to the merits or even the issues involved, the First Circuit’s opinion is one of my new favorites -- it is the first judicial opinion of which I am aware using the words "transmogrify" and "transmogrification." (Judge Selya, the opinion’s author, has a well-established reputation for using flamboyant and occasionally obscure language in his opinions.)

The word "transmogrify" in its various formulations was forever immortalized in the Calvin and Hobbes comic strip, in which Calvin turned an empty cardboard box into a "transmogrifier," capable of changing a person into "whatever you’d like to be."

There is a truly wonderful website here dedicated exclusively to the Calvin and Hobbes transmogrifier comic strips. And the excuse to be able to link here to the Transmogrifier site is more than enough justification for discussing the First Circuit opinion above.

Please click through to the site and enjoy the comic strips. They will make you smile. You too could consider turning yourself into a "500-story gastropod, a slug the size of the Chrysler Building." However, do keep in mind, as Calvin reminded Hobbes, that "transmogrification is a new technology."

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One of the recurring D&O insurance issues is the question of policy coverage for additional acquisition consideration paid to an acquired companies’ shareholders – so-called "bump up" claims. In an interesting and colorfully written September 28, 2009 opinion (here) that insurers undoubtedly will cite profusely in future disputes of this kind, District of Massachusetts Judge Nancy Gertner held that Genzyme Corporation’s D&O insurance policy did not cover amounts Genzyme paid to settle the claims of individuals who asserted they had received inadequate consideration in an exchange for their tracking shares of an internal Genzyme division.

Background

From 1993 to 2003, Genzyme’s capital structure included "tracking stock" to track the performance of separate business units within the company. In May 2003, Genzyme’s board decided to eliminate the tracking stocks, and the company announced that it would exchange the business units’ tracking stock for a certain number of the company’s General Division’s shares.

The ensuing exchange "proved to be unpopular among many Biosurgery Division shareholders," who subsequently initiated a securities class action lawsuit against Genzyme and certain of its directors and officers. The Biosurgery Division shareholders alleged that the defendants had schemed to depress the Division’s tracking stock so that Genzyme could fold the Biosurgery Division into the General Division at an exchange rate favorable to General Division shareholders. In August 2007, Genzyme agreed to settle the Biosurgery Division shareholders’ claim for $64 million. More detailed background regarding the lawsuit can be found here.

Genzyme sought to recover part of this settlement amount from its D&O insurer. The insurer denied coverage on two grounds: (1) that the settlement did not represent insurable "loss" under the policy; and (2) that coverage was precluded by the policy’s "bump up" exclusion. Genzyme initiated coverage litigation. The D&O insurer moved to dismiss.

The September 28, 2009 Opinion

Judge Gertner opened her opinion with an assessment of the "plethora of cases" on which the D&O insurer sought to rely to argue that "an insured does not incur insurable loss when she is merely forced to disgorge money or other property to which she is not entitled." Judge Gertner noted that "this legal principle is undeniably correct and would almost certainly be adapted by a Massachusetts court."

Judge Gertner then made the first of the several vivid commentaries that characterize her opinion, when she noted that

A thief should not be able to claim the return of stolen property as an insurable loss. Similarly, an individual who breaches her contract and then is forced to pay damages should not be able to seek indemnification under an insurance policy. If I pay only $100for an item for which I promised to pay $200, and I am later ordered by a court to pay the additional $100, I should not be able to claim the additional $100 as an insurable loss. Had I paid the full $200 due up front, then clearly no part of the $200 would constitute loss covered by insurance. The dilatory nature of my obligatory payment should not transform it into an insurable event.

Genzyme sought to distinguish the referenced case law by arguing that it had received no benefit to which it was not entitled or that could be disgorged. Judge Gertner agreed, noting that the company had merely reorganized its capital and issued additional shares. But while Genzyme itself did not benefit, its shareholders "surely did" benefit from the reduced exchange ratio, and the class action was "meant to redress the imbalance."

As a result of these circumstances, Judge Gertner found, this case "does not fit comfortably within the existing case law holding that the mere return of an ill-gotten gain was uninsurable." She expressly rejected the insurer’s "attempt to force this case into the existing case law."

Having determined that the existing case law was inapposite, she proceeded to address defendants’ motion based her own analysis of the question presented, which she stated to be as follow: "When a corporate pays a settlement to resolve a claim that it benefitted one group of shareholders at the expense of another group of shareholders, is this settlement payment an insurable loss?" The answer to this question, she found, "must undoubtedly be ‘no.’"

To explain this conclusion, Judge Gertner resorted to a "somewhat strained – but one hopes enlightening – hypothetical." In her hypothetical, a father and his two sons, Daniel and Eli, are in a restaurant and have ordered a singled milkshake divided into two cups. The father redistributes the milkshake between the cups in a way that leaves Daniel with two-thirds of the milkshake and Eli with one third. The father, she noted, would be expected equalize the distribution, not "to turn to the restaurant owner and demand that he provide more milkshake to make up the difference."

Drawing upon this hypothetical, she found that the lawsuit settlement had merely "recalibrated the division" in the share exchange by giving the Biosurgery Division shareholders additional cash in place of the additional shares to which they claimed they were entitled. Genzyme should not, she said, be able to demand indemnification from the insurer for what is in effect a share redistribution.

If Genzyme’s interpretation of the policy were correct, she found, "a corporation merely need issue several classes of shares, cancel one class in an arguably unfair way, and then demand that the insurer pick up the tab." She rejected this possibility noting that the policy "should not be read in a way that produces absurd results."

Judge Gertner then turned to the insurer’s alternative argument that there was no coverage under the policy for the settlement because of the policy’s "inadequate consideration" or "bump up" exclusion, which provides that the carrier is not liable for "the actual or proposed payment by any Insured Organization of allegedly inadequate consideration in connection with its purchase of securities issued by any Insured Organization." Genzyme argued that the exclusion did not apply because the share exchange did not involve a "purchase" of securities, but rather the mere exchange of one class of securities for another.

After reviewing dictionary definitions, Judge Gertner concluded that the share exchange was "unambiguously a ‘purchase’ within the natural and ordinary meaning of the word." She also found that Genzyme sought coverage under a policy provision applicable only to a "securities claim," defined inter alia as the "purchase or sale of securities." Genzyme, she noted, was contending that the share exchange was a "purchase" for purposes of relying upon the policy’s definition of securities claim, yet did not explain why the same word should have a different meaning in a different policy provision.

Judge Gertner rejected Genzyme’s further argument that even if Genzyme itself no claim in its own right under the policy, there would still be coverage for the settlement under the policy’s separate insuring clause providing reimbursement for Genzyme’s indemnification of its directors and officers.

Judge Gertner found that "it makes little sense to allow a corporation to sidestep coverage limitations in its insurance policy through the simple expedient of claiming that a settlement payment was made to indemnify its directors and officers." She noted that a contrary holding could "encourage fraud" and "chicanery," as otherwise a corporation could use calculated indemnification resolutions to try to create coverage for otherwise noncovered claims.

Discussion

Judge Gertner’s opinion is not only highly readable and even entertaining, it is also potentially significant, for a number of reasons.

First, Judge Gertner made it clear that she was not relying on prior case law in reaching her decision. As a result, her opinion potentially represents a new line of analysis in connection with the perennial questions about coverage under the D&O policy for "additional consideration" claims. In particular, her analysis does not depend on whether or not the payment for which coverage was sought was "restitutionary." Rather her analysis turned on whether the insurer could fairly be asked to pay for what was effectively a redistribution or "recalibration."

At a minimum, this line of analysis could give insurers disputing coverage for "bump up" settlements an additional ground on which to base their position, arguably without even having to get into the question whether the payment in dispute was "restitutionary." Insurers instead (or perhaps alternatively) will strain to rely on Judge Gertner’s milkshake hypothetical.

Second, and perhaps more significantly, Judge Gertner did not base her decision on the bump up exclusion alone, although she did grant the motion in the alternative based on the exclusion. The significance of the fact that she separately and independently granted the motion to dismiss on the ground that the settlement is not an insurable "loss" is that even today many policies do not contain a bump up exclusion. Indeed, over the years, many of the "additional consideration" coverage disputes that have arisen have involved policies lacking such exclusions. Judge Gertner’s reasoning could be particularly influential in future "additional consideration" disputes involving policies without bump up exclusions.

Third, even though her opinion did not rely on the prior case law holding that restitutionary payments are uninsurable, her detailed elaboration of the intellectual basis for the principles behind the case law will undoubtedly add weight (and color) to legal arguments relying on these cases.

Fourth, the decision is also significant for its interpretation and application of the bump up exclusion. As I noted in a prior post (here), these exclusions are still relatively new, vary widely, and generally have not been subject to extensive judicial scrutiny. There is still relatively little case law interpreting bump up exclusions. Judge Gertner’s enforcement of the exclusion here, particularly her conclusion that the share exchange was a "purchase" within the exclusion’s meaning, helps illuminate how these exclusions operate and how they will apply.

Finally, Judge Gertner’s opinion may be particularly noteworthy because of her willingness to dispense with prior case law formulas and to base her decision instead on a careful consideration of the underlying transaction and facts. However, I expect that not everyone is going to be equally impressed with her milkshake hypothetical. Even those inclined to cheer Judge Gertner’s opinion here should reflect on the possibility that other judges, perhaps lacking Judge Gertner’s intellectual rigor, might unburden themselves of their own hypotheticals that may or may not have anything to do with the parties’ reasonable expectations of how the policy should operate.

In any event, insurers undoubtedly will find much to like in Judge Gertner’s opinion, which is not only highly literate but highly quotable. Her colorful phrases will undoubtedly be featured heavily in insurers’ future legal briefs both on bump up claims and with respect to questions regarding restitutionary payments. The only things that may undercut insurers’ attempts to rely on the Genzyme decision are the somewhat unusual facts involved in the case. Those seeking coverage will certainly try to argue that Judge Gertner’s "redistribution" or "recalibration" analysis is restricted to the specific and unusal circumstances of the Genzyme case.

A September 29, 2009 memo by the Wiley Rein law firm summarizing the opinion can be found here. Wiley Rein represented the D&O insurer in the Genzyme coverage dispute.

Special thanks to the several loyal readers who sent me copies of the Genzyme opinion.

All That, and She’s A Fellow Blogger, Too: Readers curious about Judge Gertner’s willingness to express herself so freely in a judicial opinion may be interested to know that in addition to being a federal judge, she is also a blogger. According to a Boston Globe profile (here), she began blogging because she determined with respect to blogs (correctly in my view), that "if this is where people are getting information, this is where to be." She also noted, in an observation to which every blogger and would-be blogger will relate, that the hardest part about blogging may be finding time to blog.

She apparently has had found little blogging time lately, because there have been relatively few recent entries by any of the contributing authors on the site for which she has been blogging, the Convictions blog on the Slate website (here). (Believe me, Judge Gernter, I know all about the way a pesky day job can interfere with important blogging activities.)

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On March 2, 2009, in an opinion with important implications for the availability of coverage when a company official has inculpatory knowledge at the time of policy formation, Judge Gerald Lynch of the Southern District of New York granted the motions for summary judgment of two of Refco’s excess D&O insurers, but denied the summary judgment motion of a third excess insurer. The reasons both for the grants and the denial are instructive, particularly with respect to the interplay between varying excess forms and the language of the primary policy. A copy of the March 2 opinion can be found here.

Background

As reflected in prior posts regarding this case (here and here), this coverage dispute relates to the D&O insurance Refco procured in connection with its ill-fated August 2005 IPO. Refco’s $70 million insurance program was arranged in multiple layers, with a primary carrier and several excess carriers.

The $70 million program was arranged as follows: A primary $10 million layer; a first level excess layer of $7.5 million excess of the primary $10 million; a second excess layer of $10 million excess of the underlying $17.5 million; a third excess layer of $12.5 million excess of the underlying $27.5 million; a fourth excess layer of $10 million excess of the underlying $40 million; and a fifth excess layer of $20 million excess of $50 million. UPDATE: According to the remarks posted by an anonymous commentator, the fifth level excess policy is a Side A/DIC policy.

In October 2005, two months after Refco’s IPO, it was revealed that at the time of the IPO, Refco had an undisclosed $430 million receivable due from an entity controlled by Refco’s CEO, Phillip Bennett. Following this revelation, the company collapsed. Bennett, among others, has pled guilty to an array of criminal offenses.

Following Refco’s collapse, the company’s directors and officers were the target of extensive litigation. The primary and first level excess carriers advanced their entire combined limits of $17.5 million in payment of defense expense, subject to repayment if it is determined that there is no coverage. The four remaining excess carriers initiated litigation seeking a judicial determination of no coverage under their policies. In a June 18, 2008 opinion (here), Judge Lynch denied the second level excess carrier’s motion for summary judgment and in a subsequent opinion (here) determined that the second level excess carrier had an obligation to advance the payment of defense expense while the coverage issues were pending.

The March 2 Opinion

Judge Lynch’s March 2 Opinion relates to the motions for summary judgment of the third, fourth and fifth level excess carriers. Judge Lynch granted the motions of the third and fourth level excess carriers but denied the motion of the fifth level excess carrier.

The difference in outcome turned significantly on important differences between and among the excess policies each of the three carriers had issued to Refco. The third and fourth level excess policies were so-called "follow form" policies, meaning they followed the terms and conditions of the primary policy, except to the extent that their excess policies expressly adopted additional or different terms and conditions. The fifth level excess policy was not a follow form policy, a distinction that proved to be outcome determinative, at least for purposes of the summary judgment motions.

Each of the three policies had their own exclusionary provisions (not found in the primary policy) 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 a claim. (The relevant exclusions were described in the third and fourth level excess policies as "prior knowledge exclusions" and as an "inverted representation endorsement" in the fifth level excess policy.)

Although he took some time getting there, in the end Judge Lynch had little trouble concluding that Bennett’s knowledge of the undisclosed receivable at the time of policy formation triggered these knowledge exclusions. The critical question was whether or not Bennett’s knowledge and the operation of the exclusions precluded coverage for all of the other insureds in light of the applicable policy terms and conditions.

The availability of coverage for the other insureds in turn depended on the operation of the applicable "severability language." This language determines whether or not the knowledge of one insured can be imputed to another.

Because the third and fourth level excess insurers’ policies are "follow form," the severability language on which the insureds relied to argue that Bennett’s knowledge was not imputable to them was from the primary policy. By contrast, because the top level excess policy was not a follow form policy, but instead had its own severability language, the insureds relied on the top level policy’s language in arguing for coverage under that policy.

After a lengthy discussion whether or not the primary policy’s application severability provision applied to the excess insurer’s exclusions, the court concluded that in the end the question didn’t matter. (See the following section for the distinction between application severability and exclusion severability.) Judge Lynch concluded that, under the policies’ terms, the addition of the knowledge exclusions to the third and fourth level excess policies "superseded" any contrary language in the primary policy, including the primary policy’s severability provisions.

Since the knowledge exclusions the third and fourth level excess policies precluded coverage where any insured has knowledge of the existence of facts giving rise to the claim, Judge Lynch concluded that Bennett’s knowledge of the receivables scheme precluded coverage for all of the insureds under the third and fourth level excess policies.

By contrast, however, Judge Lynch concluded that "a number of facts unique to [the top level excess insurer] preclude granting summary judgment to the insurer." The critical distinction is that the top level excess policy had its own severability provision, which, because it was in the same policy, was not superseded by the presence of the knowledge exclusion.

In addition, the top level excess insurer’s severability language lacked a critical sentence that the primary policy’s severability language included. The severability provision in the primary policy contained, but the top level insurer’s severability provision lacked, the following final sentence: "If any particulars or statement in the Application is untrue, the Policy will be void as to any Insured who know of such untruth." Because the top level excess insurer’s policy had no such provision, which specifically linked the severability language to the application, Judge Lynch concluded that the top level insurer "had not met its burden of showing" that its severability provision applied only to the application and not also to exclusions.

The Distinction Between Application and Exclusion Severabiltiy

A critical point to try to understand what is going on in this opinion is the distinction between application severability (that is, whether or not one person’s knowledge of application misrepresentations will be imputed to other persons) and exclusion severability (that is, whether or not one person’s knowledge or actions can be imputed to another for purposes of an exclusion).

Many practitioners will likely share my puzzlement that the decision almost entirely involves the question of the arguably more general operation of application severability provisions, even though the insurers were not relying on application misrepresentations to deny coverage, but rather upon the operation of the knowledge exclusion.

The explanation is that the excess policies apparently had no exclusion severability language of their own. Since the top level excess policy was not follow form and the excess policy has no exclusion severability language, the insureds relied on the arguably generalized operation of the application severability language to contend that Bennett’s knowledge could not be imputed to them for purposes of the exclusion.

The primary policy did, in fact, have its own exclusion severability language. However, Judge Lynch concluded (in a footnote) that because of the way the primary policy’s exclusion severability provision was worded, it applied only to the exclusions in the primary policy, and not to the distinct exclusion in the excess policy. Judge Lynch found that because the primary policy’s exclusion severability language applied only to the "above exclusions," it applied only to those found (that is, literally appearing "above") in the primary policy.

Discussion

If nothing else, this case provides an object lesson of the complicated way that the various components of a single D&O insurance program can operate to produce disparate results.

The so-called "follow form" policies wound up following neither the application severability nor the exclusion severability language of the primary policy, not because the excess policies expressly disclaimed those provisions, but simply because of the way the various policies interacted with each other. This opinion certainly highlights the truly limited extent to which "follow form" excess may actually follow form.

The extension of the excess policies’ knowledge exclusions to persons without knowledge is likely to trouble at least some observers. For most of the last decade, the D&O insurance industry has struggled to try to ensure that "innocent insureds" do not lose their insurance protection due to the misconduct or misrepresentations of others . The efforts to avoid these problems have concentrated on developing application and exclusion severability language limiting the consequences from the bad actors’ misconduct to the bad actors themselves.

This opinion illustrates an issue that may not have been a part of these industry efforts to create policy mechanisms to protect innocent insureds --  that is,  the importance of clarity of the purpose and design of application and exclusion severability provisions not just at the primary level, but all the way up the tower.

Another factor in this opinion not touched on above was the uncertainty whether or not the knowledge exclusions were even part of the excess policies. In addressing this issue, Judge Lynch reviewed the communications surrounding the placement of the insurance coverage. In my view, there was nothing unusual about these communications, which reflect nothing so much as the short time frame within which these kinds of insurance programs often are put together. But while the communications themselves are not out of the ordinary, the questions that subsequently have arisen do highlight the pitfalls of the policy procurement process.

Among other things, the process (at least to the extent reflected in Judge Lynch’s opinion) seems to suggest that in connection with the placement of the excess policies, the company’s representatives accepted the knowledge exclusion in lieu of an increased limits application. The practitioners’ pointer from this case is that severability is an equally important issue with respect to the exclusion as it would be to the increased limits application. This case suggests that in order to determine whether or not the severability issue is appropriately addressed entails consideration not only of the specific exclusionary language but also consideration of the interaction of all of the pieces in the tower.

The other specific practitioners’ pointer is that the exclusion severability language in a primary policy can be (and in this case, was) worded so as to restrict exclusion severability solely to the primary policy, without effect on any exclusions that may be added in any excess policies and regardless whether or not the excess policies otherwise are follow form policies. This observation suggests the need to specifically consider the question of exclusion severability in the context of any exclusions added to excess policies.

I wish to emphasize that nothing in these observations should be taken in any way as a criticism of anyone involved in the Refco coverage placement. This case demonstrates how complicated the interaction of the various program components can be, and that the interaction of the components can even, as this case demonstrates, produce results that might not be anticipated at the time of policy placement.

One final thought has to do with the fact that the court granted summary judgment for the third and fourth level excess insurers but not for the top level insurer. There has not at this point been any determination that there is coverage under the top level insurer’s policy. But if there were, I wonder whether the court’s entry of summary judgment on behalf of the third and fourth level excess insurer would create a gap in coverage that would relieve the fifth level excess insurer from its payment obligations – or rather, because the coverage underlying the fifth level of coverage will not be exhausted by payment of loss, could the fifth level excess carrier’s policy even be triggered? Obviously, the specific trigger language in the fifth level excess policy could be critical on this issue, but I suspect that before all is said and done the argument that there is a coverage gap will come up.

A March 3, 2009 memo from the Wiley Rein law firm discussing the Refco opinion can be found here. The Wiley Rein memo discusses a number of other important aspects of this opinion that I have not addressed above. Special thanks to the several loyal readers who sent me a copy of the opinion.

The Marc Dreier Scandal: The subsequent and much larger Madoff and Stanford Financial scandals have driven the Marc Drier scandal into the background, but the Dreier scandal is in some ways even more astonishing than those larger cases. A truly fascinating account of Marc Drier’s manic passage from hyper-aggressive lawyer to identity-misrepresenting fraud is set out in a March 3, 2009 American Lawyer article entitled "Anatomy of a Crack-Up: The Marc Dreier Case" (here). Alison Frankel’s comprehensive retelling of Drier’s disturbing tale makes for compelling reading.

We Don’t Need No Stinking TARP Money: According to a March 3, 2009 CFO.com article (here), a number of regional banks have concluded they are better off without TARP money. The article cites, for example, TCF Financial Corp, a Minnesota-based bank holding company with $16.7 billion in assets which claims that it only took the money ($361.2 million) under government pressure.

The article quotes the company’s CEO as saying that "the rules have definitely changed," and that whereas at the outset the message had been that only healthy banks would be granted the funds, subsequent Treasury actions and congressional mandates have created a "public perception" that banks that took TARP money "did so out of weakness." The CEO says that this perception puts the bank at a "competitive disadvantage."

The government recovery program is in trouble if bankers become convinced there is a stigma associated with accepting government aid. Part of the problem for the banks undoubtedly is the grandstanding politicians who insist on attempting to aggrandize themselves by flaying anyone receiving government aid. Even if some (but definitely not all) bankers made a hash of it in recent years, do we really want Congress trying to tell banks what to do?

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The initiation of a criminal investigation against a company or its directors and officers can be a watershed moment in the life of any company. In addition to the question of how it will respond, the company must also determine how it will fund the associated legal expense. It is at this critical juncture that the company confronts issues surrounding the availability and limitation of D&O insurance in connection with criminal investigations.

These issues are explored in a December 2008 article by Patricia Bronte of the Jenner & Block firm entitled "D&O Coverage for Corporate Criminal Investigations" (here). As Bronte notes, the availability of coverage for a criminal investigation depends upon the particular language in the applicable policy, particularly the policy’s definition of the term "claim." The critical question will be whether or not the particular circumstances presented constitute a "claim."

The article opens with a review of case law from an earlier era, when D&O policies did not routinely define the term "claim." However, as the article discusses, the typical D&O policy now defines the term and includes within its definition a specific reference to a "criminal proceeding," which usually is further defined as having been "commenced by the return of an indictment."

One of the useful things Bronte’s article does is that by reviewing the early case law, she shows how the carriers came to insert the language limiting coverage for criminal proceedings to post-indictment matters. Prior cases where carriers were compelled to fund a wide range of expenses related to investigations and other pre-indictment matters clearly led to this change.

However, Bronte’s article also illustrates the difficulties, from the policyholder’s perspective, of this post-indictment limitation of coverage for criminal matters. That is, "a corporation’s best hope for a favorable outcome – and sometimes the best way to avoid disaster – is to persuade the prosecutor not to file any formal criminal charges at all."

As a consequence of this need to try to avert indictment, the corporation can incur considerable expense pre-indictment in respond to subpoenas, addressing a grand jury investigation, or otherwise attempting to answer the investigative threat. Costs incurred in connection with these efforts represent defense expenses, whether or the investigation ultimately results in an indictment.

Disputes over these kinds of legal costs are among the perennial battles in the D&O claims arena. Invariably, policyholders will argue that these expenses were indispensible to their post-indictment defenses, or even that they helped avert an indictment. Further complicating these discussions is the fact that these expenses associated with the pre-indictment criminal investigation often are being incurred at the same time that the company is also incurring legal expense in connection with an SEC investigation and also separate civil litigation. These various proceedings may be covered in whole or in part under the policy.

Because all of these various legal matters are going forward simultaneously and usually pertain to a single set of circumstances, sorting out which legal expenses relate to which proceeding (and therefore which expenses are covered under the policy) can become a vexing problem and source of tension between the policyholder and the carrier.

Exacerbating these problems is the fact that among all these proceedings, the criminal matter usually looms the largest and therefore may consume the larges amount of legal effort and expense. This is particularly true if, as is often the case, the individuals involved each retain separate counsel. The potentially massive expense associated with the criminal investigation underscores why these issues can be so critical.

In light of these considerations, the article offers some practical suggestions. Bronte notes:

Brokers and risk managers should press for "claim" definitions and coverage limits that adequately protect the corporate entity from the expense of criminal investigations, which almost inevitably involve multiple teams of lawyers defending the corporation and its employees.

In that regard, many D&O insurers now include within the definition of the term "claim" not only a reference to post-indictment (or post-information) criminal proceedings, but also a separate explicit reference to "investigations" (including criminal investigations), usually delimited in some way around the requirement for the naming of an insured person as a target of a possible indictment. The precise wording of the definitional provisions relating to "investigations" potentially could be critical.

In addition, at least one major carrier now has a form that removes any reference to an indictment requirement, and instead refers simply to "criminal proceedings." The removal of the indictment requirement, together with the reference to "proceedings," at least potentially opens the door to coverage for grand jury investigations, subpoenas, and other matters. While this alternative wording is not universally or even widely available, it does present an alternative for consideration.

The article also notes, in connection with efforts to secure coverage for criminal proceedings that "policyholders do not advance their position if they or their brokers characterize the criminal investigation as merely a ‘potential claim.’" An alternative possibility is to refer to the matters involved as a claim, or, in the alternative, a potential claim.

The article correctly points out that "the high cost of defending against accusations of criminal wrongdoing is one of the reasons that corporations purchase D&O insurance." Nevertheless, the extent of coverage for criminal proceedings remains one of the perennially disputed claims issues. The further development of D&O policy wordings that better address policyholder expectations is a continuing challenge for the D&O insurance industry and one on which there are fruitful areas for further discussion.

More About NERA’s Year-End Securities Litigation Study: In a prior post (here), I linked to NERA Economic Consulting’s year-end report on 2008 securities litigation activity. (The report itself can be found here). In a December 19, 2008 post (here), the Securities Docket has an interesting interview with the report’s authors, my good friends Stephanie Plancich and Svetlana Starykh. Among other things, the interview quotes the authors as saying, with respect to their projections for litigation activity in 2009:

While our paper does not forecast trends into the next year, our best guess is that filing activity will remain high into 2009. As mentioned above, there have been a number of new filings in late December — traditionally a slow time for litigation activity — indicating that the rate of filings has yet to decrease.

And while the first credit crisis cases were concentrated in the financial industry, there has been an emerging trend of credit crisis- and recession-related filings emerge outside of the financial sector.

Ghost of Christmas Preset, 2008 Version: With apologies to Charles Dickens, I excerpt below an imagined version of his holiday classic, updated for current circumstances. We can only hope that the Ghost of Christmases Yet-to-Come bears happier tidings. 

And taking Scrooge by the arm, the Spirit lifted him high above the financial landscape. Below him, Scrooge could see a parade of spectacles he scarcely could have imagined: the largest bank failure ever; the largest bankruptcy ever; the largest government bailout; the collapse of the housing market and the near-collapse of the entire financial system. 

"Spirit!" said Scrooge. "Show me no more! Conduct me home. Why do you delight to torture me?"

"One Shadow More!" exclaimed the Ghost.

And below, in the mist, Scrooge could see an avuncular man. Oddly and incongruously, the man wore a baseball cap. 

"Who is that man, Spirit?" Scrooge asked.

"Those who used to think of themselves as his friends called him ‘Bernie’" the Spirit said.

"No more!" cried Scrooge. "No more, I don’t wish to see it. Show me no more!"

Break in the Action: I think we could all use a break. I will discontinue my regular publishing schedule for the next few days. Regular publication will resume after the New Year.

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A December 15, 2008 opinion (here) in a Delaware bankruptcy court adversary proceeding provides a rare judicial interpretation of an "inadequate consideration" exclusion in a D&O insurance policy. I have reproduced with permission below a summary of the case prepared by the Wiley Rein law firm, followed by my own brief commentary. The firm’s case summary, which appears in the indented text below, can also be found here.

Case Summary

A federal bankruptcy court, applying New York law, has dismissed an adversary proceeding brought by a bankrupt home mortgage company against its directors and officers liability insurers, holding that coverage for a pre-petition lawsuit against the mortgage company was barred by application of an "inadequate consideration" exclusion. Delta Fin. Corp. v. Westchester Surplus Lines Ins. Co., Case No. 07-11880 (CSS) (Jointly Administered) (Bankr. D. Del. Dec. 15, 2008).  The court also held that the coverage dispute was a non-core proceeding.  Wiley Rein LLP represented one of the insurers in this case.

The underlying lawsuit arose from the mortgage company’s 2001 restructuring transaction.  In connection with that transaction, the mortgage company allegedly first convinced its unsecured and senior secured note holders to surrender their notes to a newly-formed holding company for which the note holders were granted certain interests in the holding company.  Next, the holding company returned the senior notes to the mortgage company, and, in exchange, the mortgage company transferred excess "cash flow certificates" to the holding company.  The mortgage company and the holding company intended that value of the exchanged senior notes and cash flow certificates would each be approximately $153 million.

In 2003, the former note holders filed suit against the mortgage company and its directors and officers alleging that, at the time of the restructuring transaction, the cash flow certificates had an actual fair market value of only $43 million.  The plaintiffs ultimately asserted eight causes of action against the defendants concerning various aspects of the restructuring transaction.  The mortgage company tendered the suit to its directors and officers liability insurers, and the primary insurer denied coverage based in part on the inadequate consideration exclusion.  In 2007, the mortgage company filed for Chapter 11 and brought an adversary proceeding against the insurers seeking damages and a declaratory judgment that the insurers were obligated to advance defense costs and provide indemnification for the underlying lawsuit.

In considering the insurers’ motions to dismiss, the bankruptcy court focused on the primary policy’s inadequate consideration exclusion, which provided that "[t]he insurer shall not be liable for Loss on account of any Claim made against any Insured: . . . based upon, arising out of, or attributable to the actual or proposed payment by the Company of allegedly inadequate or excessive consideration in connection with the Company’s purchase of securities issued by any company."  Noting that New York courts rely on a "but for" causation test to interpret insurance exclusions with "arising from" lead-in language, the bankruptcy court conducted a three-part analysis to determine whether the pre-petition lawsuit was excluded by the inadequate consideration exclusion. 

First, the bankruptcy court noted that each of the plaintiffs’ eight causes of action sought damages related to the harm caused by the alleged difference between the senior notes, worth $153 million, and the cash flow certificates, worth $110 million less. 

Second, the bankruptcy court determined that this harm would not have existed "but for" the restructuring transaction, and, thus, the restructuring transaction was the "operative act." 

Finally, the bankruptcy court concluded that the operative act was explicitly encompassed by the inadequate consideration exclusion because the restructuring transaction involved an "actual payment" by the mortgage company of "inadequate consideration"—the cash flow certificates—in connection with the mortgage company’s purchase of "securities issued by any company"—in this case, its own senior notes.  Accordingly, the bankruptcy court determined that the exclusion barred coverage for the underlying complaint in its entirety.  As a result of that determination, the court did not reach the insurers’ other argument that the amount at issue in the underlying case did not constitute "Loss" as defined by the policies.

After concluding that all of the mortgage company’s claims in the adversary proceeding were barred by the inadequate consideration exclusion, the bankruptcy court rejected the mortgage company’s waiver and estoppel arguments, which were based on the passage of 18 months before the primary insurer denied coverage.  The bankruptcy court noted that, under New York law, an insurer could not waive a defense to coverage, and the mortgage company had failed to allege sufficient facts demonstrating its reliance on the failure to issue a coverage position.  Finally, relying on the reasoning in In re Stone & Webster, Inc., 367 B.R. 523 (Bankr. D. Del. 2007), the bankruptcy court agreed with the insurers that the adversary proceeding was a non-core proceeding.

Commentary

In recent years, it has become increasingly common for D&O carriers to issue policies containing "inadequate consideration" exclusions, or as they are sometimes known, "bump up" exclusions. Carriers designed these exclusions to address disputes that sometimes arise in connection with merger objection lawsuits.

These kinds of lawsuits routinely emerge after the announcement of a merger or acquisition. Invariably, plaintiffs’ attorneys file a lawsuit claiming that the acquired company’s shareholders were receiving inadequate consideration for their shares in the acquired company. These lawsuits sometimes end with the defendant acquirer agreeing to pay some additional consideration. The acquirers then sometimes try to pass these increased acquisition costs to the D&O insurers. The carriers object to paying amounts that they contended was merely a transaction cost and did not "loss" as a result of a wrongful act.

In order to try to avoid disputes over these increased consideration, or "bump up," amounts, some carriers have attempted to insert exclusions for "inadequate consideration" claims into their policies. These kinds of provisions are not always included in D&O policies, nor is the wording in the various exclusions used in the marketplace uniform. In addition, there is very little case law interpreting these kinds of provisions.

The Delta Financial decision highlights a number of noteworthy aspects of the particular exclusion language used in the applicable policy that may be important in connection with the wording of these kinds of exclusions.

First, it is important to note that the allegations of inadequate consideration were made in connection with the company’s acquisition of its own securities, rather than those of another company. The court’s ruling certainly underscores the significance of the exclusion’s use of the word "any" in the phrase "the securities issued by any company," as opposed to, for example, the possible alternative use of the word "another." Had the exclusion used the word "another" rather than "any," the outcome could well have been different.

Although it was not relevant in the context of this particular dispute, the exclusion’s reference only to "securities" also highlights the possible outcome determinative impact in other situations if the exclusion were also to refer to "assets of" in addition to the "securities issued by" any company. The exclusion’s reference only to securities, as opposed to both securities as well as assets, is narrower, as a result of which the exclusion would, in this respect at least, have a narrower preclusive effect.

Many readers undoubtedly noted that this case arose out of the bankruptcy of a residential mortgage origination and servicing company that funded its lending operations by selling interests in securitized pools of mortgages, a business pattern that is not unfamiliar these days (nor indeed is the bankruptcy itself unfamiliar these days). The procedural context, and perhaps even the substantive dispute, may presage a host of disputes that may lie ahead in connection with the subprime and credit crisis-related litigation wave.

In any event, the outcome of the coverage dispute underscores a point that I have made many times in the past on this blog—that is, the critical importance of policy wording.

Very special thanks to Dan Standish of the Wiley Rein firm for providing a copy of the Delta Financial opinion and for allowing me to reproduce his firm’s case summary.

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A recent appellate court opinion interpreting a D&O liability insurance policy securities exclusion carries some important reminders both about policy wording precision and about exclusionary language, and also raises some critical questions about the scope of coverage for securities claims generally.

In an October 27, 2008 opinion (here), the Eighth Circuit, applying Minnesota law, held in the In re SRC Holding Corp. case that there is no coverage under a D&O liability insurance policy containing a securities claims exclusion for claims made against a financial services company and certain of its directors and officer for alleged wrongful acts in connection with the company’s underwriting and sale of certain municipal bonds.

Following a description below of the case’s background and the appellate court’s holding, I discuss the implications of the Eighth Circuit’s decision.

Background

Between 1996 and 1999, Miller & Schroeder (M&S), a securities underwriter and broker, underwrote and sold $140 million of municipal bonds. The bonds later defaulted and the bond investors initiated lawsuits and arbitration proceedings against M&S and certain of its directors and officers, alleging breaches of federal securities laws and other violations. M&S ultimately went into bankruptcy.

M&S’s D&O insurance carrier denied coverage for the claims. The bankruptcy trustee initiated a lawsuit against the D&O insurer alleging breach of contract and seeking a judicial declaration of coverage. The individual M&S directors and officers intervened in the trustee’s action.

The bankruptcy court held that the policy exclusion on which the insurer relied to deny coverage did not preclude coverage for all of the claims and that the carrier must defend the individuals against all claims. The district court affirmed the bankruptcy court’s ruling and the carrier appealed.

The Eighth Circuit’s Decision

On appeal, the carrier argued that the district court erred in finding that the policy required the carrier to provide the directors and officers with defense cost coverage and indemnification for the bond investors’ claims.

The carrier relied on Endorsement No. 3 to the policy, which provides that:

In consideration of the premium charged, this Policy does not apply to any Claim based on, arising out of, directly or indirectly resulting from, in consequence of, or in any way involving any actual or alleged violation of:

(1) the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, any other federal law, rule or regulation with respect to the regulation of securities, any rules or regulations of the United States Securities and Exchange Commission, or any amendment of such laws, rules or regulations; or

(2) any state securities or "Blue Sky" laws or rules or regulations or any amendment of such laws, rules or regulations; or

(3) any provision of the common law imposing liability in connection with the offer, sale or purchase of securities.

The district court held that this exclusion precluded coverage only for M&S’s sale of its own securities, but not otherwise. In reaching this conclusion, the district court relied in part on the testimony of the insurance broker who sold the policy, who testified, according to the appeals court, that "this standard-form securities exclusion is typically intended to exclude coverage for liability resulting from the insured’s sale of its own stock."

As the appeals court paraphrased the district court’s logic, because the provision had a "typical effect," the meaning of the provision "must accord with that typical effect." The district court said that this was the only interpretation that "makes sense."

The appeals court held, however, that the district court erred in relying the broker’s testimony. Because the district court held (correctly in the appellate court’s view) that the provision is unambiguous, it was erroneous as a matter of Minnesota law for the court to rely on extrinsic evidence in interpreting the provision.

The Eighth Circuit said that "the effect of [the securities exclusion] as it may be generally applied in practice is not the legal authority that governs our coverage inquiry here; it is the mutually agreed-upon policy’s plain language that binds [the parties] in the first instance." The appeals court noted that

Sophisticated business entities who rely on experts to advise them are best suited to determine what makes the most economic sense and the language they have mutually negotiated and agree to is the best evidence of what those parties intended.

The appeals court held that the endorsement is "not limited to claims arising out of M&S’s sale of its own securities," as such a limitation "is nowhere to be found in its language."

The appeals court also rejected the suggestion that this interpretation was inconsistent with other provisions in the policy.

The insureds argued further that in any event coverage for claims against them for alleged violations of NASD rules were not precluded, and therefore that the carrier was obliged to fund the defense, even as to non-NASD proceedings.

The appeals court rejected this argument as well, in reliance on the Endorsement No. 3’s broad preamble ("based upon, arising out of, directly or indirectly resulting from, in consequence of, or in any way involving…"), as well as the policy’s provisions broadly treating interrelated matters as a single claim.

Because the alleged NASD violations "arise out of, flow from and have their origins in the same set of operative facts" as the claims alleging violations of the securities laws, for which coverage is broadly excluded under the policy, they fall "well within the ‘arising out of’ exclusionary language of Endorsement No. 3."

The Wiley Rein law firm, which represented the carrier before the appellate court, has a detailed memorandum here summarizing the Eighth Circuit’s decision is greater detail.

Discussion

The Eighth Circuit’s ruling is noteworthy in and of itself, as a federal appellate court decision vigorously holding that insurance policies negotiated between sophisticated parties must be interpreted strictly according to their terms.

The opinion also represents a cautionary tale for practitioners in this area, and it is well worth considering more fully in that light.

None of my remarks are meant in any way as a criticism of the broker involved. Clearly, the broker’s view of how this policy should operate had a substantial basis, as both the bankruptcy court and the district court adopted the broker’s interpretation.

However, the Eighth Circuit’s opinion is a harsh reminder that, notwithstanding what the common understanding may be about the meaning or operation of policy provisions, ultimately courts will look at a policy‘s actual language. As the Eighth Circuit’s opinion demonstrates, a court’s policy interpretation may or may not coincide with common understandings or expectations. For practitioners in this area, the appellate court’s ruling underscores that what matters is wording not intent.

In addition, the court’s reliance on the breadth of Endorsement No.3’s exclusionary preamble is a reminder of the inclusive nature of this type of omnibus language. The Eighth Circuit found that the use of this broad preamble substantially extended the reach of the provision’s exclusionary effect, which represents its own reminder to practitioners of the critical importance of the way in which policy provisions are framed, particularly policy exclusions.

A critical part of the coverage dispute here relates to the fact that the securities violations alleged arose not in connection transactions involving the insured company’s own securities. This aspect of the dispute raises a more general question about how, in the absence of a securities claim exclusion, D&O insurance policies should respond to claims of securities law violations asserted by persons other than the insured company’s own shareholders.

There have been some high profile 2008 examples of securities lawsuits filed by persons other than the defendant company’s own shareholders. The numerous auction rate securities claims represent one example. Another example is the securities class action lawsuits filed against, among others, Hexion Specialty Chemical and certain of its directors and officers by shareholders of Huntsman Corporation. The Huntsman shareholders alleged that the Hexion defendants "deceived the investing public regarding Hexion’s efforts and intentions with respect to the merger with Huntsman." (Refer here for further background about the Hexion claim).

These recent examples, as well as the M&S case discussed above, underscore the possibility of securities allegations by persons other than a company’s own shareholders. These kinds of claims can arise not only in connection with financial companies, like M&S and the companies involved in the auction rate securities cases, but can also involve non-financial companies, like Hexion.

Questions of policy coverage for these types of securities lawsuits potentially could be significant not only in connection with the type of exclusionary language in the M&S case, but also in connection with the definition of "securities claim" found in the typical D&O insurance policy.

There are standard formulations for the definition of the term "securities claim." One formulation is oriented toward claims arising under the securities laws and the other is oriented toward claims involving the issuer’s securities or the issuer’s securities holders.

Definitions of the term "securities claim" oriented toward the securities laws themselves will extend more broadly without respect to who has asserted a claim and are more likely to encompass securities lawsuits filed by persons other than a company’s own shareholders.

Definitions of the term "securities claim" tied to claims involving the company’s own securities, rather than more broadly to claims involving the securities laws generally, could be interpreted more narrowly with respect to securities lawsuits brought by persons other than the company’s own shareholders.

All of which begs the question: how should the policies respond to securities lawsuits against insured persons filed by claimants other than the company’s own shareholders? In my view, because these claims allege wrongful acts by persons insured under the policies, they represent precisely the kind of litigation for which the policy should provide coverage. Of course, whether any particular policy will respond to this kind of claim depends on the actual policy language.

Financial Collapse: The Board Game: According to a November 28, 2008 Financial Times article entitled "Icelanders Collapse in Laughter" (here), some Icelanders, tapping into their typically "darkly ironic sense of humor" have developed a board game "that takes a grimly comical swipe at the financial crisis that has devastated the economy."

Players roll dice and move around the game board while drawing cards that, for example, allow them to buy a private jet or obtain a foreign loan, or perhaps go bust. Icelanders have been suggesting additional content for the cards via the Internet. Among other cards suggested is one reading "Go to demonstrate at parliament, stop to buy some eggs to throw, only to realize that prices have gone up so much you can’t afford them."

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A recurring D&O insurance coverage concern involves the question whether the standard pollution exclusion typically found in most D&O policies could preclude coverage for a securities lawsuit alleging pollution-related misrepresentations or omissions. An August 15, 2008 opinion (here) by a New Jersey intermediate appellate court addressed this issue squarely.

The New Jersey Superior Court Appellate Division per curiam opinion affirmed a trial court determination, in a coverage case arising out of a securities class action lawsuit alleging misrepresentation of contingent asbestos liabilities, that the "alleged pollution at issue was too attenuated from the damages arising from the alleged misrepresentations to trigger the pollution exclusion."

Background

The underlying case arose out of a series of complex corporate recapitalization, reorganization and merger transactions, as result of which Sealed Air Corporation acquired certain assets and liabilities previously held by W.R. Grace. In post-transaction statements, Sealed Air made representations concerning its contingent liability for asbestos-related claims retained by a spun-off subsidiary.

As a result of asbestos liability lawsuits against the spun-off subsidiary, the subsidiary sought bankruptcy protection. The bankruptcy court later determined that the corporate reorganization transaction represented a fraudulent conveyance. After the fraudulent conveyance ruling became public, Sealed Air’s stock price plunged.

Sealed Air shareholders initiated a securities class action lawsuit against the company and its directors and officers. Background regarding the securities lawsuit can be found here. The company sought coverage for its litigation costs from its D&O insurer. The D&O insurer denied coverage in reliance upon the pollution exclusion in its policy. The pollution exclusion precludes coverage, in pertinent part, for loss "based on, arising out of, or in any way involving: (a) the actual or threatened discharge, release, escape, seepage, migration or disposal of Pollutants."

Sealed Air filed a declaratory judgment action against the insurer. Following a trial in the coverage action, the trial court entered judgment in the company’s favor, requiring the insurer to advance the company’s securities litigation defense expense. The insurer appealed.

The Appellate Ruling

On appeal, the insurer argued that the exclusion should be "given a literal reading," contending that "the language and effect of the Policy’s pollution exclusion is clear and unambiguous." Sealed Air, for its part, argued that "the alleged loss to shareholders arises out of the allegedly misleading financial statements, not from air-borne pollutants." The company contended that because "the alleged damages arise from securities misrepresentation and not traditional environmental pollution," the policy provides coverage.

The New Jersey Superior Court Appellate Division found that "the language of the policy at issue precludes [the insurer] from disclaiming based on the pollution exclusion." The court said that "it is clear to us that the gravamen of the securities holders’ complaint has its root in securities fraud and misrepresentation, not pollution." The Court found that the pollution on which the insurer sought to rely "is too attenuated from the damages sought and the legal grounds supporting such alleged damages."

The appellate court specifically addressed the insurer’s argument that the broad preamble to the exclusion, precluding coverage for loss "based on, arising out of, or in any way involving" excluded pollution. The appellate court concluded that the damages sought in the securities lawsuit were neither "based on" nor "arising out of" excluded pollution. In concluding that the "in any way involving" wording similarly did not trigger the exclusion, the appellate court noted:

Read together with the surrounding words, "based on" and "arising out of," in the context of the pollution exclusion clause, "in any way involving" requires a more direct causal relationship between the pollution and the harm. [The insurer’s] interpretation of the pollution exclusion is too broad, unfair and contrary to the reasonable expectations of the insured.

The appellate court concluded that the "plain and ordinary language of the policy, as well as the reasonable expectations of the insured," prevent the insurer from precluding coverage.

Discussion

As a preliminary matter, it should be noted that the appellate court’s opinion is designated as "Not for Publication." Under Rule 1:36-3 of the New Jersey Rules of Court (here), "no unpublished opinions shall constitute precedent or be binding on any court." In addition, under the Rule, an unpublished opinion cannot be cited "unless the court and all other parties are served with a copy of the opinion and of all other relevant unpublished opinions known to counsel including those adverse to the position of the client."

While the appellate court’s opinion is therefore of no precedential authority and of only restricted persuasive potential, there are nonetheless lessons that can be derived from the case.

First, it should be noted that Sealed Air was able to establish its entitlement to coverage under the Policy for its defense expense incurred in defending against the securities litigation only after enduring a trial and subsequent appeal (and any other proceedings that the insurer may yet pursue in its attempt to deny coverage). It clearly is in the interest of any policyholders for their policy to clarify that the policy is intended to provide coverage for securities claims, even if the underlying misrepresentations alleged relate in some way to pollution.

In the current marketplace, many carriers will agree to provide a coverage carve back from the pollution exclusion specifying that the exclusion does not in any event apply to securities claims or to shareholders’ derivative actions.

In addition, in the current marketplace, many carriers will also agree to modify the exclusion’s preamble so that rather than the broad preamble wording found in Sealed Air’s policy, the preamble specifies that the exclusion applies only if the claim is "for" excluded pollution. This wording provides some measure of protection against carrier attempts to rely on remote connections between the actual claim against the insured persons and underlying facts involving pollution as a basis to deny coverage.

It should also be noted that certain of the so-called Side A/DIC policies available in the marketplace do not contain pollution exclusions. Depending on the coverage provided under these policies, the policies could potentially "drop down" and provide a measure of protection for individual defendants if the first line D&O insurer denies coverage for a claim based on the pollution exclusion.

One final note pertains to the underlying securities claim. I have previously commented (most recently here), about the possibility that growing social and political pressures relating to climate change issues could lead to climate change-related claims against directors and officers of publicly traded companies, particularly in connection with climate change-related disclosures. My views in this regard have met with some interest, but also with some skepticism.

The underlying securities lawsuit involved here demonstrates how shareholders might allege that a company did not fully disclose, for example, its contingent liabilities arising out of climate change-related issues. The Sealed Air case suggests (to me at least) how short the leap might be to these kinds of allegations. But the risk, however measured, underscores the need for the policy-wording issues identified above to be addressed.

An August 28, 2008 memorandum from the Wiley Rein law firm discussing the outcome of the Sealed Air coverage appellate decision can be found here.

Securities Docket: Bruce Carton of the Unusual Activity blog (here) has launched a new securities litigation news website called the Securities Docket (here). The Docket bills itself as a "globlal securities litigation and enforcement report." The first iteration is certainly visually attractive and full of a wide variety of interesting items. The Docket looks like it will be an interesting resource that we intend to monitor closely. Congrats to Bruce on getting the Docket launched.

WSJ RIP: Joe Nocera of the New York TImes has a post on his Talks Business blog (here) in which he mourns the death of the Wall Street Journal -- not the death of the newspaper itself, just its death as the repository of important business news. I have felt the same things that Nocera expresses for a while. The pre-Rupert Murdoch WSJ filled a valuable role that no one other paper (or other news source) plays. Now instead of a unique and indispensible source of business news, it is just one more source for stories about politics that have already been reported in any number of our media sources. I agree with Nocera --  I miss the old Journal a lot.

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It remains to be seen whether the current economic turmoil will result in significant additional bank failures. But if history is any guide, to the extent that there are further bank failures, there likely will also be follow-on lawsuits in which the regulators pursue claims against the failed institutions’ former directors and officers. As these claims emerge, there may also be disputed issues regarding the applicability of the failed institutions’ D&O insurance policies.

As I noted in a recent post (here), among the issues that may arise is the applicability of the regulatory exclusion. In addition, another issue that may arise relates to the potential applicability of the so-called “insured v. insured” exclusion found in most D&O insurance policies.

The “insured v. insured” exclusion typically precludes coverage for claims by or on behalf of the insured corporation, its affiliates or directors and officers against other insured persons. Over the years, the standard exclusion has been modified to provide coverage carve-backs for certain types of claims for which coverage would otherwise be precluded, such as derivative claims and employment practices claims.

During the S&L crisis in the late 80s and early 90s, the federal banking regulators actively pursued claims against the failed institutions’ former officials. As described in a July 29, 2008 memorandum from the Latham & Watkins law firm entitled “The ‘Insured v. Insured’ Exclusion in D&O Policies” (here), many of these regulator claims implicated the insured v. insured exclusion.

As the law firm’s memorandum explains, in many instances the regulators were able to argue successfully that the exclusion should not apply to preclude coverage for their claims, because the lawsuits were not the “collusive” type disputes for which the exclusion historically was meant to preclude coverage. However, as the memorandum also notes, there were cases in which the exclusion was held to bar coverage for the regulators’ claims, on the grounds that the regulator was in effect “standing in the shoes” of the failed institution.

The memorandum correctly points out that the “insured v. insured” exclusion is “heavily litigated” and “continues to be at the heart of many coverage disputes.” There are a number of reasons why coverage disputes involving the exclusion are so frequent.

First, over the years, the scope of persons insured under the typical D&O policy has expanded – for example, to include “employees” within the definition of insured persons for purposes of securities claims. In addition, many companies for their own reasons have sought to schedule additional named insureds to the policy by endorsement. While these policy extensions may be desirable from the policyholder’s perspective, problems can arise later if the extensions are not also coordinated with the language and operation of the “insured v. insured” exclusion.

Second, companies may take on forms or structures that raise fundamental questions about who is an insured under the policy. For example, insolvent companies may continue in business as a debtor-in-possession or may have its activities taken over by a receiver. These and other situations have raised and continue to raise a myriad of contentious questions about the scope and applicability of the insured v. insured exclusion.

Third, in many lawsuits, the plaintiffs’ claims may be based on information or assistance provided by former company officials. The former officials’ involvement may run afoul of the wording in the typical insured v. insured exclusion, which specifies that for claims to be covered they must be “instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of” any insured person.

The question whether a former official’s litigation involvement falls within one of these precluded categories is a frequent source of contentious coverage disputes. (Refer here for discussion of a recent case involving these issues.) In order to try to reduce the opportunities for these types of disputes, many carriers will now agree upon request to add wording providing that the exclusion will not apply in the event of the involvement of former officials whose departure was more than a specified amount of time before (typically, four years).

As the Latham & Watkins memorandum discusses, one of the issues frequently disputed in these cases is whether the underlying claim must be “collusive” in order for the exclusion to be triggered. As the Latham & Watkins memo explains, the exclusion’s original intent was to bar coverage for collusive claims. However, not all courts have required collusion for the exclusion to be applied (refer, for example, here), although there are many jurisdictions in which collusion has been held to be required.

The importance of the “insured v. insured” exclusion and the opportunities to revise the standard wording to reduce the exclusion’s preclusive effect highlights the importance of addressing these basic wording issues at the time the policy is purchased. As the Latham & Watkins memorandum notes, each company “should seek the assistance of an insurance broker to attempt to limit the exclusion’s breadth.” The potential significance of these issues underscores the need for companies to enlist the assistance of an experienced and knowledgeable broker in their acquisition of D&O insurance.

Duties of Outside Directors Under Delaware Law: As noted by the ever-vigilant Francis Pileggi on his Delaware and Commercial Litigation Blog (here), on July 29, 2008, the Delaware Chancery Court issued an opinion in the Ryan v Lyondell Chemical Company case (opinion here) that has important implications for the duties and potential liabilities of outside directors in the merger and acquisition context.

The court held that the outside directors were not entitled to summary judgments and would have to stand trial for their role in the sale of the company, as Pileggi notes, “despite selling the company to the only known buyer for a substantial premium.”

As explained in the opinion, when the Lyondell board received the offer, it delegated much of the negotiations to the company’s Chairman and CEO; never conducted a “market check to determine whether a better price could be obtained; agreed to a deal that included protective rights, including a “no-shop provision.” Moreover, “the whole deal was considered, negotiated, and approved by the Board in less than seven days.”

The Chancery Court held that the Board could not invoke the exculpatory provisions under the company’s charter and the Delaware Code because “the Board’s apparent failure to make any effort to comply with the teachings of Revlon and its progeny implicates the directors’ good faith and, thus, their duty of loyalty, thereby, at least for the moment, depriving them of the benefit of the exculpatory charter provision.”

Pileggi’s post does an admirable job explaining the implications of the decision. Further valuable analysis of the decision can be found on the Legal Profession Blog (here).

Monster Settlement, Dude: As reflected in its July 31, 2008 press release (here), Monster Worldwide has reached a settlement in the options backdating related securities action lawsuit pending against the company and certain of its directors and officers. As reflected in the press release, the settlement consists of “a payment to the class by the defendants of $47.5 million in full settlement of the claims asserted in the securities class action. The Company's cost is anticipated to be approximately $25 million (net of insurance and contribution from another defendant).”

The Monster settlement is only the latest of the options backdating related securities class action settlements. A full list of settlements and case dispositions in the options backdating related litigation can be accessed here.

A WSJ.com Law Blog post describing the Monster settlement (and containing a nice link to The D&O Diary) can be found here.

The Securities Litigation Watch blog as updated its detailed analysis of the options backdating securities class action lawsuits, which can be found here.

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On June 26, 2008, Judge Gerard Lynch of the Southern District of New York issued another opinion (here) in the D&O insurance coverage litigation arising out of the Refco debacle (My recent post discussing Judge Lynch’s prior opinion in the case discussing insurance application issues can be found here.)

In yet another judicial decision that resonates with significance for excess D&O insurance issues, Judge Lynch, hearing an appeal from a bankruptcy court ruling, addressed the question whether an excess insurer may withhold advancement of defense costs based on its determination that an exclusion in its policy precluded coverage. Judge Lynch held that even if the excess policy has the distinct exclusions, the policy's terms do not  affect the operation of the applicable defense cost advancement provisions, and the advancement provisions should be enforced according to their terms.

The background of the case can be found in my prior post. Of significance here, the primary insurer’s $10 million limit and the first level excess insurer’s $7.5 million were exhausted in payment of defense expense. As also discussed in the prior post, the second level excess insurer disputes coverage on a number of grounds. The second level excess insurer also disputes that it has any obligation to advance defense costs pending a determination of coverage.

The parties agree that the advancement provisions in the primary policy control the advancement issue; they dispute how the provisions apply in the context of the second level excess carrier’s policy.

The primary policy specifies that:

The Insurer will pay covered Defense Costs on an as-incurred basis. If it is finally determined that any Defense Costs paid by the Insurer are not covered under this Policy, the Insureds agree to repay such non-covered Defense Costs to the Insurer.

The second level excess insurer [hereafter in this post, simply “the insurer”] contended that notwithstanding this language, it has no obligation to advance defense costs. In making this argument, the insurer relied on the word “covered” in the first sentence of the advancement provision, qualifying the type of defense costs that the provision requires to be paid on an as-incurred basis.

The insurer’s argument is based on its contention that its policy’s conduct exclusions, unlike the primary and first level excess policies’ exclusions, do not have an adjudication requirement. The insurer argued, according to the court, that because the conduct exclusions in its policy have no adjudication requirement, “prior to a court determination, [the insurer] has the unilateral right to determine whether defense costs are ‘covered,’” and that it has made a “good faith determination” that the insureds’ claims are precluded under its policy.

As the court paraphrased the insurer’s position, the insurer contended that the terms of its contract “authorize it to apply its exclusions to deny coverage unilaterally – and thus to refuse to advance defense costs – unless and until a court determines that the costs are ‘covered’” under its policy.

The insureds contend in their counterclaim in the coverage litigation that the exclusions on which the insurer relies to deny coverage “are not, in fact, part of the policy.” With respect to the advancement issue, the insureds argued that the advancement provisions require the insurer to advance defense expense, contending that as long as the claim “falls within the policy’s insuring agreement, it is covered unless and until there is a final determination that an exclusion applies.”

The insureds also argued that nowhere in the insurer’s policy does it state that the insurer can unilaterally withhold defense expense absent a court determination, and nothing in the insurer’s policy states that its exclusions are not subject to the “final determination” language in the second sentence of the advancement provisions.

In his June 26 opinion, Judge Lynch observed that “in essence, the central dispute among the parties centers on who bears the burden regarding whether defense costs are ultimately covered.” Judge Lynch, while noting that the insurer’s position regarding advancement “is not unreasonable on its face,” also noted that the insurer’s interpretation “places enormous emphasis on the word ‘covered.’” Judge Lynch said that the word’s inclusion in the advancement provisions “can hardly be said to make an unambiguous change in the provision’s literal meaning,” and “seems, at best, an unusual way to effectuate a fundamental change in the parties’ expectations.”

Because the court found the wordings to be ambiguous, it interpreted the provision in favor of the insureds – a result that the court noted “makes eminent sense, as adopting [the insurer’s] interpretation … would effectively render the advancement obligation worthless.” Judge Lynch concluded by saying that if the insurer “wants the unilateral right to refuse a payment called for in the policy, the policy should clearly state that right.” (citations omitted)

Whatever else might be said about the court’s opinion, it is certainly a sharp reminder of the importance of inclusion of adjudication requirements in the D&O policy’s conduct exclusions. If, in the absence of an adjudication requirement, the insurer may contend (as did the insurer in the Refco coverage litigation) that it has the unilateral right to determine coverage and withhold policy benefits, then the omission of adjudication requirements is perilous indeed for insureds.

But the crux of the dispute is whether the second level excess insurer’s policy contains exclusions not found in the primary or first level excess policies. The insureds apparently dispute that the exclusions are part of the second level excess policy (although the precise nature of that dispute is not clear from the face of the opinion). Assuming that the distinct exclusions are in fact part of the second level excess insurer’s policy, it does suggest that the insurance program is something less than pure “follow form” insurance. Indeed, many insurance programs that are characterized as “follow form” in fact have characteristics that may make them something less than follow form, a consideration that may sometimes be overlooked in the insurance transaction process.

It is of course true that each policy in a tower of insurance represents a separate contract. Excess insurers have every right to insist on terms differing from the underlying layers. The Refco coverage dispute highlights the pitfalls that can arise when (or perhaps if) an excess policy has terms that differ from the underlying policies. Indeed, the arguments raised by the second level excess insurer in the Refco coverage litigation show that differences in wording between the layers potentially can cause the different layers to operate quite differently, potentially in ways that may not necessarily be apparent or anticipated.

One final note has to do with the parties’ apparent dispute whether the exclusions are in fact part of the second level excess policy. It is hard to tell from the face of the opinion, but this dispute may be due to the process issues discussed briefly in my prior post. At least until the merits are sorted out, it may be premature to try to draw any conclusions. But as I noted in my prior post, and to the extent the dispute is due to process issues, this case may be a reminder of the opportunities for and the dangers of ambiguities in insurance placement process communications. From the perspective of every process participant, after a serious claim has arisen is a very difficult time to have to try to sort out, for example, whether or not exclusions are part of a policy.

Special thanks to Kelly Reyher for providing me with a copy of Judge Lynch's June 26 opinion.

And Finally: For those of us laboring in the salt mines of the blogosphere, it is always exciting when a fellow blogger steps out in some dramatic way. And so I was delighted to see in the July 16, 2008 Wall Street Journal that Mark Herrmann of the Drug and Device Law Blog published a book review critically analyzing the recent book "Side Effects" by Alison Bass. Kudos to Mark for his excellent and well written review.

May all new media practitioners continue to prosper and succeed. Gradus ad Parnassus.

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In a June 25, 2008 decision (here), the Delaware Superior Court (New Castle County) refused to apply a D&O policy adjudicated fraud exclusion to preclude coverage for the settlement, defense fees and costs incurred in connection with an underlying securities lawsuit.

The coverage action arose out of the AT&T Corporation Securities Litigation, the background regarding which can be found here. The case ultimately settled for $100 million. Prior to the settlement, the trial court granted the defendants’ motion for partial summary judgment, narrowing the case. The case went to trial on the remaining issues, but the parties reached a settlement before the jury reached a verdict. The court in the subsequent coverage litigation specifically noted that “there is no dispute that no court has held, and no jury has every found, that AT&T or any of the defendants in the Common Stock Litigation engaged in any deliberate, dishonest, fraudulent, or criminal act or omission.”

The primary policy in the applicable D&O insurance program provided in its base form that the insurer “shall not be liable to make any payment in connection with any Claim: brought about or contributed to in fact by any dishonest, fraudulent or criminal act or omission.” However, by Endorsement, this exclusion was deleted and replaced by language providing that he insurer is not obligated to pay any claim:

brought about or contributed to in fact by any deliberate dishonest, fraudulent or criminal act or omission, or any personal profit or advantage gained by any of the Directors and Officers to which they were not legally entitled and providing any such finding is material to the cause of action so adjudicated.

The primary carrier’s $20 million limit had been exhausted through payment of defense fees and costs. The first level excess carrier provided $25 million in “follow form” excess coverage. The excess carrier refused to pay either defense fees or contribute toward the settlement, claiming that the fraud exclusion bars coverage.

The Delaware court first turned to the question of what law to apply. The court ultimately determined that New York law governed. Interestingly, the basis of the court’s decision was language in the fourth level excess carrier’s policy. Because the court assumed that the parties’ intended that only one jurisdiction’s law would govern the entire program, the court found that the fourth level excess carrier’s language controlled even though the fourth level excess policy sits above the first level excess carrier’s policy.

The court then turned to the merits of the insurance coverage issue. The court paraphrased the exclusion as precluding coverage “for deliberate, dishonest, fraudulent, or criminal acts or omissions upon ‘such finding is material to the cause of action so adjudicated.’”

The court said that “no fact finder considered all the evidence and rendered a ‘finding” or verdict.” The court also observed that neither the summary judgment ruling nor the settlement adjudicated anything.

The court also specifically ruled that “the ‘adjudication’ contemplated in the policy does not, as [the excess insurer] asserts, mean an adjudication within the coverage dispute. It means an adjudication in the underlying action.” The court specifically noted that the excess insurer “cannot argue its way around” the change that the Endorsement introduced in the dishonesty exclusion wording. The court said the position argued by the excess carrier is “belied by the plain language of the policy.” The court added that “it is not a close question.” The court also observed that “to hold the fraud exclusion applicable” to a securities claim in the absence of an adjudication “would effectively eviscerate the purpose of the policy.”

The precise wording at issue in the AT&T coverage case is not typically used today. But the court’s analysis is nevertheless important as it pertains to the adjudication requirements for the typical adjudicated fraud exclusion that is found in many policies today. The court’s refusal to read into the clause a right by the insurer to adjudicate the issue of fraud in a separate coverage case amounts to a ruling that an adjudication fraud exclusion does not permit the fraud issue to be separately litigated, at least absent language to the contrary.

This is an important holding because while most contemporary D&O policies have an “adjudicated” fraud exclusion, there are also still some other policies that allow the insurer to litigate the fraud exclusion in a separate proceeding. The court’s holding in the AT&T case underscores the point that, without the separate proceeding language, the “”adjudication” referenced in the fraud exclusion pertains to the underlying proceeding, and the fraud exclusion therefore is inapplicable if there has been no fraud determination in the underlying proceeding.

The excess carrier’s inability to further litigate the fraud issue in the ATT&T coverage case also demonstrates the value to the policyholder of fraud exclusion language that does not permit separate adjudication. The presence of separate adjudication language potentially could have permitted the AT&T coverage litigation to go forward and potentially could have led to a finding that could have barred coverage. For that reason, a fraud exclusion that permits separate adjudication is undesirable from the policyholder’s standpoint. In the current insurance environment, most policyholders should be able to obtain adjudicated fraud exclusion language without any provision allowing separate adjudication.

A couple of final points about the decision. The first is that yet again a coverage dispute has arisen in which the excess carrier contested coverage after the primary carrier’s limits were exhausted. As I have frequently noted (most recently here), the D&O insurance industry continues to be challenged with issues arising as losses escalate through the insurance tower. The problem of excess insurer coverage disputes is an increasingly important issue that the industry must address.

Second, the court’s resolution of the question of the law to be applied to the first level excess carrier’s policy based on language in the fourth level excess carrier’s policy is interesting but at the same time potentially troublesome. The court’s reasoning seems practical and informed by a desire to reach a common sense solution; it is logical that only one jurisdiction’s law   should apply to the entire tower.

The troublesome part is the court’s reference to upper layer policy provisions to resolve lower layer issues. The lower layer insurers often are unaware of provisions in the upper layer policies, and problems could emerge if the view were to develop that the meaning of lower layer policies can be discerned from language in upper layer policies. Maybe this concern reads too much into the court’s opinion, but the mere suggestion is troubling.

Very special thanks to Francis Pileggi at the Delaware Corporate and Commercial Litigation Blog (here) for alerting me to the AT&T coverage decision and providing me a copy.

Nearer to the Heart’s Desire: A July 12, 2008 Cleveland Plain Dealer article (here) reports that 34 Ohio charitable organizations will share a $14 million pool of uncollected money from a class action lawsuit. The settlement arose out of a class action lawsuit based on an auto insurer’s alleged overcharges for uninsured motorist coverage. The case settled for $51 million, but when some of the funds went unclaimed, the plaintiff class’s attorney succeeded in having the doctrine of “cy pres” applied to the unclaimed funds so that, rather than going back to the defendant insurer, the funds would go the charitable organization.

The term "cy pres" is law French, derived from the phrase  cy pres comme possible  -- meaning as near as possible or as close as possible to the original intent. The phrase is sometimes relevant in the trust and estates context when the trustor’s or the testator’s original intentions can no longer be fulfilled due to changed circumstances.

The concept of a cy pres settlement is actually not new, although it apparently has gained popularity recently among certain plaintiffs’ attorneys. Ted Frank wrote an interesting article earlier this year entitled “Cy Pres Settlements” (here) in which he discusses other recent cy pres settlements and some of the problems they present.

The phrase has a certain poetic quality, and not merely because of its gallic residue. The very concept is almost literary, as it requires an exercise of the imagination to implement. I have always felt this attribute of the doctrine is nicely summarized in the lines from The Rubaiyat of Omar Khayyam: “Ah Love! could you and I conspire/To grasp this sorry scheme of things entire/Would not we shatter it to bits—and then/Remold it nearer to the heart’s desire!”

And Finally: In a recent post (here), I discussed an academic paper in which three Stanford professors analyzed four corporate governance companies’ governance ratings. In the post, I expressly invited the governance rating companies, if they so desired, to provide a response to my discussion of the academic paper.

In reply to my invitation, Ric Marshall, the Chief Analyst of The Corporate Library, and Kimberly Gladman, the Director of Research and Ratings at The Corporate Library, sent me a response, which I have added to the end of my original post.

Because Ric and Kimberly make a number of interesting points, I urge all readers to refer back to the now updated post (here) to see their comments.

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A June 18, 2008 opinion (here) by Judge Gerald Lynch in the coverage litigation between former Refco directors and officers and one of the company’s excess D&O insurers presents a veritable conflagration of policy application issues, including perennial questions concerning warranties, severability, and imputation, as well as a host of related issues arising from the policy procurement process itself.

Background: In the year preceding Refco’s ill-fated August 2005 IPO, Refco had maintained a $30 million D&O liability insurance program (the 2004-2005 program). In connection with its IPO, Refco obtained a total of $70 million of D&O insurance for the period from August 11, 2005 to August 11, 2006 (the 2005-2006 program). Both programs were arranged in multiple layers, with a primary carrier and several excess carriers.

In connection with placement of the 2004-2005 program, Refco completed the primary carrier’s insurance application (the “Application”). In addition, one of the excess insurers (and the ultimate litigant in the coverage dispute) required that the company submit a Warranty Letter on behalf of all insureds, affirming that no person for whom the insurance was proposed is “cognizant of any fact, circumstance, situation, act, error or omissions which … might afford grounds for any Claim.”

The Warranty Letter, submitted to the excess carrier on January 21, 2005, was signed by Phillip Bennett, Refco’s CEO. It later was revealed that Refco had an undisclosed $430 million receivable due from an entity Bennett controlled. The company subsequently collapsed, and Bennett, among other has pled guilty to an array of criminal offenses.  

At least as appears from the June 18 opinion, there were no additional applications or warranties in connection with the placement of the 2005-2006 program.

Following Refco’s October 2005 collapse, the company’s directors and officers were the target of extensive litigation, for which they sought defense expense coverage under the 2005-2006 program. The primary and first layer excess carriers advanced their entire limits (totaling $17.5 million) in payment of defense expense, subject to repayment of it is determined that there is no coverage under the policies.

The Coverage Denial:

The second level excess insurer, by letter dated March 6, 2006, denied coverage for the claims under its 2005-2006 policies. As the basis for its denial, the second level excess insurer relied on the representations in the Warranty letter and Refco’s failure to answer question 12(b) on the primary carrier’s Application (which asked whether any proposed insured was “aware of any fact, circumstance or situation” that might give rise to a claim).

The second level excess insurer also relied on a “Knowledge Exclusion” that was included in the insurer’s policy when issued in March 2006 (which was at or about the same time as the insurer issue its coverage denial). The Knowledge Exclusion essentially provides that the second level excess insurer is not liable for any loss (including defense expense) “in connection with any claim arising out of, based upon or attributable to any claim, fact or circumstance disclosed or required to be disclosed” in Question 12(b) of the Application.

The Coverage Litigation:

In May 2007, the second level excess insurer initiated an adversary proceeding in bankruptcy court seeking a judicial declaration of noncoverage under its 2005-2006 policy, largely for reasons enumerated in its March 2006 denial letter. Several of the individual Refco officers and directors filed an answer and counterclaim, among other things seeking an injunction compelling the second level insurer to advance defense fees. The bankruptcy court entered an order in October 2007 requiring the insurer to advance defense expense, which the insurer has now done, as a result of which its $10 million limit is now depleted.

The second level excess carrier refilled its declaratory judgment complaint in federal district court, again seeking a judicial declaration of noncoverage. The individuals refilled their counterclaims, seeking a determination of coverage. The parties filed cross motions for summary judgment, which were the subject of the June 18 opinion.

The June 18 Opinion

In reviewing the court’s rulings, it is important to note that the summary judgment motions were filed pre-discovery. This unusual procedural posture was a critical factor in the court’s decisions process, as the court, pursuant to established authority, was reluctant to interject merits-based rulings where further discovery might provide additional factual context.

The insureds argued that the Warranty Letter had been submitted in connection with the placement of the 2004-2005 program and therefore was not a part of the second level carrier’s 2005-2006 policy. The insurer for its part argued that the Warranty Letter did relate to the placement of the 2005-2006 policy and that in any event it relied on the Warranty Letter when making underwriting decisions in connection with the 2005-2006 policy. The insurer submitted an affidavit from its underwriter in support of its assertions. Judge Lynch concluded that “genuine issues of material fact abound as to whether the Warranty Letter is properly part of the 2005-2006 [policy].”

The insureds further argued that in any event, the applicable “severability provision” bars the insurer from imputing Bennett’s knowledge to the other insureds and therefore the Warranty Letter could not serve as a basis to deny coverage to them. The severability provision was contained in an Endorsement to the Primary Policy. The insurer argued that the severability provision restricted the imputation of knowledge exclusively to statements in the primary insurer’s Application, and therefore it had no bearing on the second level excess insurer’s ability to rely on the Warranty Letter, which was not part of the Application. Judge Lynch agreed, and he therefore denied the insureds’ summary judgment motion based on the application severability provision.

Judge Lynch similarly rejected the second level excess insurer’s attempt to rely on Bennett’s failure Question 12(b) on the Application. Judge Lynch found that the insurer’s issuance of its 2005-2006 policy without challenging the omission of an answer to Question 12(b) was a waiver of any objection to coverage on that basis.

With respect to the second level excess carrier’s attempt to rely on the so-called Knowledge Exclusion to deny coverage, the insureds argued that the insurer’s coverage binder had not listed the Knowledge Exclusion as an endorsement that was to be added to the policy, nor had the company’s broker authorized the addition of the Knowledge Exclusion. The insureds argued that the insurer had “unilaterally changed the terms of the 2005-2006 [policy] after learning of the events that would give rise to a claim.”

The insurer countered that the company’s broker had authorized the addition of the exclusion. The insureds contended this response “fundamentally misconstrues” the meaning of the broker’s communications. These arguments clearly reflect the detailed particulars and disputed meaning of communications between the broker and the underwriter, which Judge Lynch found suffices to raise a genuine issue of material fact precluding summary judgment on the issue.

The insureds further arged that the severability of exclusions language in the primary policy precluded application of the Knowledge Exclusion to them. They argued that even if Bennett’s knowledge triggered the exclusion, the excluded state of mind could not be imputed to them. Judge Lynch found that the severability of exclusions provision in the primary policy applied only to the exclusions in the primary policy, and not to the Knowledge Exclusion which was found only in the second level excess insurer’s policy.

Discussion:

The court’s opinion does not represent a definitive conclusion either for or against coverage under the policy. Indeed, at its most basic level, the court’s opinion merely represents a determination to allow discovery as a prelude to a later merits-based determination.

But the opinion raises too many questions about the potential availability to insurers of coverage defenses, and about the limitations of insureds’ policy protections, for the opinion not to raise a host of concerns. The concerns fall into two basic categories – that is, the concerns that are substantive and the concerns that are procedural.

The substantive concerns are numerous and relate to many of highest profile issues in the D&O insurance arena, including the use, applicability and duration of warranties and warranty letters; the extent of protection afforded to “innocent insureds” by severability provisions (including both application severability and exclusion severability); and the extent to which insureds may (or may not) be able rely on policy protections in the primary policy to preclude the assertion of policy defenses by an excess insurer.

The procedural concerns are perhaps equally significant for practitioners in the field. Judge Lynch’s opinion underscores the potential importance of communications between broker and underwriter and is a reminder of the opportunities for and dangers of ambiguities in communications (or, as the insureds would argue, supposed ambiguities). Perhaps these issues will get sorted out in later decisions in the case, but current state of play in the case raises troubling concerns about the pitfalls of the policy procurement process while providing little guidance (except by negative inference) about how those pitfalls might be avoided in the future.

There may yet be further ruling in the case that will clarify the issues. But the opinion nevertheless highlights that many of the issues the industry has been struggling with for the last decade – including in particular severability and imputation issues – remain very much alive and continue to pose significant concerns, and indeed may have edges that have not previously been addressed or even contemplated.

Two final observations about the case. The first is that the parties appear to have exhausted at least $27.5 million of the $70 million tower on defense expense alone, which is yet another reminder of the extraordinary expense involved in catastrophic type claims (a topic I discussed in a recent post, here).

The other observation is that yet again a critical D&O coverage decision has arisen in a case involving defenses raised by a follow-form excess insurer (see my prior comments on this issue here). The issues involved here underscore the myriad of difficulties that potentially can arise as losses escalate through a multilayer program. I do not mean to suggest any views one way or the other about the merits of the excess carrier’s positions in this case. Indeed, given the circumstances involved in this claim, it is unsurprising that the insurers might raise questions. Nevertheless, the specific issues in dispute suggest a level of flex in the interplay between the primary and excess layers that many policyholders would find disconcerting.

Special thanks to Michael Early for sending along a copy of the opinion. I hasten to add that the views and opinions expressed in this post are exclusively my own.

My recent post discussing whether Phillip Bennett's use of the D&O insurance proceeds was an appropriate factor in his criminal sentencing can be found here. My prior post regarding the D&O insurance implications of Bennett's cooperation with the class action plaintiffs can be found here.

What Awaits Those Who Spurn Berkshire: A June 25, 2008 Bloomberg article (here) reports that while recently addressing a group of Toronto business executives, Warren Buffett was asked what makes people want to sell their companies to Berkshire. Buffett reportedly said that he tells a prospective seller to think of their company as a work of art:

You can sell it to Berkshire and we’ll put it in the Metropolitan Museum; it’ll have a wing all by itself; it’ll be there forever. Or you can sell it to some porn shop operator, and he’ll take the painting and he’ll make the boobs a little bigger and he’ll stick it in the window, and some other guy will come along in a raincoat, and he’ll buy it.

And Finally: If you have not yet seen this amazing catch by the Fresno Grizzlies’ ball girl, you have to watch this video. It is truly marvelous. [UPDATE: I have to add that a reader advised me that the video may be a hoax, refer here -- alas. It is still an awsome video.]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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One of the standard provisions of the typical D & O insurance policy is a clause requiring the insurer’s prior consent to settlement. This clause can be the source of tension between carriers and policyholders, and policyholders and their counsel sometimes view the clause as little more than an impediment. However, a March 13, 2008 opinion (here), the New York Court of Appeals makes it clear that policyholders who disregard the settlement consent requirements do so at peril to coverage under the D & O policy.

The insurance coverage dispute in the case arose out of the securities analyst/conflict of interest investigation that unfolded earlier in this decade. Among the investment banks targeted in investigation was Bear Stearns. On December 20, 2002, Bear Stearns entered a settlement in principle with the regulators in which it agreed to pay a total of $80 million, with $25 million allocated as a penalty, $25 million in disgorgements, $25 million for independent research, and $5 million for investor education.

On April 21, 2003, Bear Stearns executed a consent agreement in which it acceded to the entry of final judgment in the SEC’s pending enforcement proceeding. Bear Stearns also agreed to payment of the $80 million and explicitly agreed not to seek insurance coverage for the $25 million penalty.

Three days after executing the settlement agreement, Bear Stearns sent letters to its D & O carriers requesting the carriers’ consent to the settlement. Bear Stearns sought coverage for $45 million of the settlement (which represented the settlement amount, excluding the penalty, in excess of the policy’s $10 million self-insured retention). The insurers disclaimed coverage and initiated a declaratory judgment action.

In October 2003, the federal court presiding over the regulatory enforcement action entered judgment on the terms to which Bearn Stearns previously had agreed.

The insurers disputed coverage on a number of grounds, but because the Court of Appeals opinion addresses only the consent to settlement issue, that is the sole issue I discuss in this post.

Bear Stearns’ primary D & O insurance policy had a provision specifying that:

The Insured agrees not to settle any Claim, incur any Defense Costs or otherwise assume any contractual obligation or admit any liability with respect to any Claim in excessof a settlement authority threshold of $5,000,000 without the Insurer's consent, which shall not be unreasonably withheld . . . The insurer shall not be liable for any settlement, Defense Costs, assumed obligation or admission to which it has not consented.

The New York Supreme Court (trial court) found that triable issues of fact existed whether Bear Stearns breached the consent to settlement clause. The Appellate Division modified the lower court’s opinion in certain other respects, but affirmed the Supreme Court on the consent to settlement issue. The Appellate Division then certified the case to the New York Court of Appeals.

The Court of Appeals, in an opinion written by Justice Victoria A. Graffeo, held that “Bear Stearns breached [the consent] provision when it executed the April 2003 consent agreement before notifying the insurers or obtaining their approval.” The Court of Appeals said that it was “unpersuaded by the contention that a triable issue of fact exists because the federal court did not approve the settlement until it entered a final judgment in October 2003.”

Judge Graffeo specifically noted that

As a sophisticated business entity, Bear Stearns expressly agreed that the insurers would "not be liable" for any settlement in excess of $5 million entered into without their consent. Aware of this contingency in the policies, Bear Stearns nevertheless elected to finalize all outstanding settlement issues and executed a consent agreement before informing its carriers of the terms of the settlement. Bear Stearns therefore may not recover the settlement proceeds from the insurers.

The Court of Appeals reversed the Appellate Court and granted the carrier’s motion for summary judgment. Because of its ruling on the consent provision, the Court of Appeals did not reach the other issues on which the carriers disclaimed coverage.

There may well have been additional grounds that could also have precluded coverage here, but it is still an arresting development – and a cautionary tale – that the Court of Appeals precluded coverage altogether based solely on the failure to obtain advance consent to settlement. Significantly, the Court of Appeals enforced the consent provision without superimposing any requirement for the insurer to show that it was prejudiced in any way by the failure to obtain consent. The Court of Appeals focused strictly on the policy’s language.

Companies and their counsel sometimes regard the consent settlement requirement as if the language were merely precatory, or perhaps even as optional if they believe settlement circumstances suggest the need to press ahead without bringing the carrier into the loop. It is not an unprecedented development for a carrier to learn of a settlement only after the fact. But the Bear Stearns opinion provides unambiguous notice to companies and counsel that they disregard the policy’s advance consent requirement at peril of precluding coverage.

The larger lesson here is that the carrier should be kept in the loop. Indeed, the better practice, the one likeliest to produce the best claim outcomes, is for companies and their counsel to treat the carrier as a collaborative partner in the claims process. While there are unfortunate situations where the carrier does not respond appropriately, even in those situations the policyholder will be better off (for example, before a court if coverage litigation ensures) if the policyholder has consistently maintained professional and timely communications with the carrier.

And whatever else may be said, it is clear, at least in New York, that the D & O policy provision requiring the carrier’s advance consent to settlement means what it says, and policyholders should take care to comply with its requirements.

Special thanks to a loyal reader for providing a copy of the New York Court of Appeals opinion.

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