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

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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In an earlier post (here), I discussed the March 14 , 2007 ruling (here) in the CNL Resorts case, in which the federal district court held that an issuing company's settlement of a claim under Section 11 of the Securities Act of 1933 did not constitute covered "loss" under the company's D & O liability insurance policy. In that prior case, the court did say that Section 11 settlements are not per se uninsurable, and noted that "in a Section 11 case, if an entity makes a payment that constitutes something other than disgorgement of its ill-gotten gains, it has suffered a loss."

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