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

Many organizations purchase management liability insurance to provide liability and defense cost protection for their directors and officers. But the management liability insurance protects the individuals only for their actions undertaken in an “insured capacity.” The policies are not intended to not protect them for actions they undertake in a capacity other than as a director or officer of the organization. These issues proved to be determinative in the action to decide whether or not D&O insurance issued to Jerry Sandusky’s organization, The Second Mile, covered the legal fees Sandusky incurred defending criminal and civil allegations involving misconduct with children.

In a March 1, 2013 Memorandum Opinion, Middle District of Pennsylvania Chief Judge Yvette Kane held that because the alleged misconduct did not arise in Sandusky’s capacity as an employee or executive of The Second Mile, the organization’s management liability insurer had no obligation to provide him defense cost coverage. A copy of Judge Kane’s opinion can be found here. As I note below, I have some concerns about this ruling.

Background

Sandusky founded The Second Mile in 1977. From 1977 until Sandusky was criminally indicted for offenses against children. Sandusky served at times as a volunteer and at times as an executive-level employee of the organization. In November 2011, a grand jury returned a report charging Sandusky with multiple crimes involving children. Following a trial, Sandusky was convicted of a total of 45 charges involving offenses against children. Sandusky has appealed his criminal conviction. Sandusky has also been named as a defendant in a separate civil proceeding brought by one of his alleged victims.

Sandusky sought coverage for the attorneys’ fees incurred in both the criminal and civil matters from The Second Mile’s management liability insurer. Sandusky sought coverage under both the D&O and EPL portions of the policy. The insurer advanced Sandusky’s defense expenses subject to a reservation of its rights under the policy and initiated an action seeking a judicial declaration that it had no obligation to fund Sandusky’s defense expenses. The insurer filed a motion for judgment on the pleadings, arguing that it would be against Pennsylvania public policy to indemnify Sandusky for the child molestation charges against him. As discussed here, in a June 2012 order, Judge Kane agreed that it would be against Pennsylvania public policy for the insurer to indemnify Sandusky, she reserved the question of whether it would be against public policy for the insurer to provide Sandusky with a defense.

After Sandusky’s criminal conviction, the insurer moved for summary judgment, arguing that the acts alleged against Sandusky were not undertaken in an insured capacity. The policy defined the term “Insured Capacity” to mean “the position or capacity of an Insured Person that causes him to meet the definition of Insured Person.” Sandusky argued that the meaning of this provision is ambiguous and the further discovery was required to determine the extent of the coverage provided under the policy. 

The March 1 Opinion

In her March 1, 2013 memorandum opinion, Judge Kane granted the carrier’s motion for summary judgment. She found the policy language regarding “Insured Capacity” to be “unambiguous.” She said that in order to determine “whether the actions that form the basis of the claims against Defendant were performed in his capacity or role as an executive or employee of The Second Mile,” she must review the allegations against him. She then reviewed the various abuse allegations that had been alleged against Sandusky. Among other things, she noted that the alleged abuse was alleged to have taken place in a variety of locations, all away from The Second Mile’s facilities.

Based on this review, she concluded that “it is clear that Defendant Sandusky was not acting in his capacity as an employee or executive of The Second Mile in sexually abusing and molesting the victims named in the criminal and civil cases brought against him, and the Court so finds.” She added that Sandusky was not alleged to have engaged in the alleged misconduct “in furtherance of his duties for The Second Mile.” She noted that the fact that Sandusky met his victims through The Second Mile or even that he sexually abused victims “during the course of activities at” The Second Mile “does not change the fact that his sexual abuse of children was personal in nature and performed in his individual capacity.” Because Sandusky’s alleged conduct “was clearly personal in nature and not in furtherance of his duties for The Second Mile, he is owed no criminal defense under the Policy.”

Discussion

The nature of these allegations is so repugnant and the fact that Sandusky has been convicted criminally makes it hard to spend any time thinking about the issues here. I certainly have no interest in defending Sandusky or trying to prove that he has not been dealt with fairly here.

Nevertheless I do have concerns about this ruling. It is easier to see my concerns if we forget about Sandusky and imagine instead that a volunteer or employee of a nonprofit organization has been unfairly targeted by abuse allegations, perhaps as a particularly vindictive part of a smear campaign. Let us say for purposes of this hypothetical that the allegations, though false, are otherwise as heinous as those against Sandusky.

My concern is that under Judge Kane’s ruling, even this falsely accused individual could not look to his origination’s management liability insurer for a defense. Her ruling does not depend on Sandusky’s conviction. She expressly says that “Sandusky’s offenses against children –whether proven or alleged – were not conduct in his capacity as an employee or executive of the Second Mile.” The allegations alone are enough to determine coverage, because “sexual abuse of children” is “personal in nature” and is “performed in individual capacity.” She even said that this conclusion would apply “even if he sexually abused victims “’during the course of activities of Second Mile.’” 

If the mere fact that allegations of sexual abuse are personal and individual is enough to preclude coverage for Sandusky, then are mere allegations sufficient to preclude coverage even for a nonprofit official who is falsely accused as part of a smear campaign? Keep in mind, Kane is not interpreting a clause of a policy in which the insurer says “we won’t insure even allegations of sexual molestation.” She was interpreting a clause that talks about the capacity in which a person was sued and for which he or she got sued. In our smear campaign hypothetical, the only reason my hypothetical smear campaign individual was targeted was because they were an official of the nonprofit. Are we prepared to say that this falsely accused individual is under no circumstances entitled to a defense, simply because of the nature of the allegations?

I would be much more comfortable all the way around with this decision if it were based on the fact that Sandusky was actually convicted. Of course, given that his criminal case is still on appeal the judgment in the criminal case is not final, and so the insurer might not be able to preclude coverage on the basis of the criminal conviction for some time yet.

When Judge Kane says that her conclusion that Sandusky was not acting in an insured capacity applies even though he allegedly abused victims “during the course of activities of Second Mile,” that’s when I get uncomfortable with this result. It would be very easy to shrug this result off because of the terrible things for which Sandusky was convicted. But because Judge Kane’s conclusion does not depend on the conviction, this same result could apply to any nonprofit official, even one who is falsely accused and would otherwise be forced to defend him or herself against outrageous allegations without insurance and at their own expense. I am very uncomfortable with this whole subject matter, but I am also not entirely comfortable with this decision.

I invite readers to weigh in on this topic, particularly those who take a different point of view on this decision than I do. (I know I am setting myself up for a raft of messages about the need for separate sexual molestation coverage or the possible problems with the bodily injury exclusion in the typical D&O insurance policy, and perhaps other similar arguments as well. Please bear in mind that my concerns here are focused exclusively on Judge Kane’s reasoning in denying coverage, not on whether there may be other questions that might affect coverage or whether there are alternative insurance arrangements that might better address the sexual molestation exposure.)

Whistleblower Watch: In my annual year-end round up of D&O insurance and liability issues, I more or less said that I thought 2013 would be the year of the whistleblower, or at least the year in which the whistleblower bounty provisions of the Dodd Frank Act kick into high gear. Well, here we are into the third month of 2013, and there still haven’t been any more whistleblower bounty awards. So was I wrong? Maybe I was, but before you decide, you need to take a look at the list that Mary Jane Wilmoth has been compiling over at the Whistleblower Protection Blog.

As Wilmoth reports, the SEC posts Notices of Covered Action when a final judgment order, by itself or with prior orders and judgments in the same action, results in monetary sanctions over $1 million. Individuals who voluntarily provided the SEC original information that led to successful enforcement in the actions identified in the Notices are eligible to apply for whistleblower awards. Once the Notices are posted, individuals have 90 days to apply for an award. The blog post lists 22 actions in which Notices have been posted. The list is complete through February 8, 2013. From looking at the dates on which the Notices have been posted, the SEC is putting up Notices regularly. The pretty clear inference is that this list is going to get a lot longer very rapidly.

Obviously not all of the Notices will lead to whistleblower bounty awards. Indeed, many will not, as there may not be a qualifying individual. But it seems highly probable that there will be some awards, perhaps many. In other words, it still seems possible that 2013 will be the year in which whistleblower bounty provisions kick into high gear. Stay tuned.

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A company’s D&O insurance policy provides liability protection for the company’s individual directors and officers, but only for their actions undertaken in their capacities as directors and officers. It does not protect them when they are acting in a personal capacity. So, when a company’s CEO signs a loan guaranty for the company, is he acting in an official or personal capacity, and will the D&O insurance policy provide protection for liability under the guaranty? Those were the questions addressed in a May 14, 2012 decision of a three-judge panel of the Court of Appeals of the State of Washington. A copy of the opinion can be found here.

Background

In March 2008, S-J Management LLC (SJM) obtained a $3.5 million line of credit from Commerce Bank. Michael Sauter, SJM’s CEO and manager, signed the loan agreement and promissory note in his official capacity on behalf of SJM. In addition Sauter provided Commerce Bank a guaranty, which he signed as “Michael J. Sauter” and which was secured by seven deeds of trust on real property owned by Sauter and his wife.

In May 2009, SJM’s line of credit matured and SJM failed to pay its indebtedness. Commerce Bank demanded that Sauter pay in full under his “personal guaranty of indebtedness” SJM’s $2.8 million obligation. Sauter in turn demanded that SJM indemnify him for the amount he was obligated to pay, to which SJM’s members (of which Sauter was one) agreed. However, SJM was financially unable to indemnify Sauter. After Commerce Bank threatened that Sauter’s failure to cure the default could result in the sale of the six real properties securing the guaranty, SJM’s counsel tendered the bank’s demand to SJM’s D&O insurer.

SJM’s insurer denied coverage with respect to Sauter’s obligation, and Sauter filed an action against the insurer seeking damages and a judicial declaration of coverage. The parties filed cross motions for summary judgment. The trial court denied Sauter’s motion but granted the insurer’s motion, holding that there was no coverage because no act by Sauter constituted a “Wrongful Act” under the policy and Sauter suffered no “Loss” as defined by the Policy. Sauter appealed.

The Appellate Court’s May 14, 2012 Opinion

In an opinion written for the three-judge panel by Judge Stephen J.  Dwyer and applying Washington law, the intermediate appellate court affirmed the trial court’s ruling. The court noted that the policy provides that an act by an “Insured Person” constitutes a “Wrongful Act” only when that person commits the act “while acting in [his or her] capacity as…such on behalf of the Insured Organization.” An “Insured Person” acts “in his capacity as ...such on behalf of the Insured Organization” when that person commits the act in his or her official capacity as a “director, officer, general partner, manager or equivalent executive” of the insured company.

In recognition of this language, the court said that because the policy “explicitly provides coverage for the personal liability of the corporate officer incurred for acts performed in his or her capacity as such,” the policy “does not insure against losses incurred where the officer acts in his or her personal capacity.”

The court said that “the fact that Sauter is an officer of SJM is not dispositive of the question presented,” which is -- in what capacity did Sauter sign the guaranty, his capacity as an officer or his personal capacity? The Court noted that “a guaranty executed by a corporate officer that secures the indebtedness of the corporation is not executed in the officers’ official capacity.” Indeed, the execution of the guaranty in an official capacity “would result in the corporation itself guaranteeing its own indebtedness, thus negating the very purpose of the guaranty.”

Because Sauter was acting in his personal capacity when he signed the guaranty, Sauter committed no “Wrongful Act” as defined in SJM’s D&O insurance policy, and thus the court concluded that the policy does not provide coverage for Sauter’s financial obligation to Commerce Bank.

The Court went on to note in addition that any purported “Loss” suffered by Sauter did not result from a “Claim” made against Sauter for a “Wrongful Act.” Rather, the court noted, “Sauter incurred the obligation to pay SJM’s indebtedness by executing the guaranty – not by failing to satisfy his obligation pursuant thereto.” In other words, the court said, “his obligation to Commerce Bank was not the result of Commerce Bank’s demand on the guaranty; instead his obligation was the result of the guaranty itself.” Accordingly, because his obligation to pay was the result of his voluntary undertaking, “it is not a ‘Loss resulting from any Claim … for a Wrongful Act.”

Discussion

D&O insurance policies protect individual directors and officers. But that protection does not extend to everything those individuals might do. Rather, the protection only extends to their actions undertaken in their capacities as directors and officers, not to actions undertaking in the personal capacities.

There principles are easy to state, but the lines of demarcation between actions undertaken in an official capacity and actions undertaken in a personal capacity may not always be clear. This case illustrates how the lines can sometimes be difficult to discern. Here, it was SJM that wanted to borrow the money, and Sauter was clearly motivated by a desire to facilitate SJM’s borrowing. What matters though is not his motivations but his actions. When he signed the loan agreement and the promissory note, he was clearly acting in his official capacity. But he separately signed a guaranty. Sauter’s guaranty was designed to obligate Sauter not the corporation, and his undertaking was clearly a separate, personal undertaken, as evidence by the fact that the guaranty was secured by deeds of trust on property owned by Sauter and his wife.

There is a further reason why Sauter’s guaranty should not be the responsibility of the insurance company. One cannot undertake an obligation to pay, default on that obligation, and send the bill to the insurance company. For that reason, many courts have held that as a matter of public policy repayment of a contractual obligation does not represent a Loss under a D&O insurance policy. As discussed here, many D&O policies incorporate express contractual liability exclusions.

Coverage disputes arising from the questions of whether or not an individual was or was not actin g in an insured capacity are occur frequently, particularly in connection with smaller or closely held corporations, when an individual’s roles may overlap or run together. It may sometimes be very difficult, for instance, in the context of a closely held company to distinguish when an individual is acting as an investor or shareholder and when the individual is acting as a director or officer.

Indeed, in many instances, individuals may have been acting in dual capacities or multiple capacities, which can make questions concerning coverage for related claims particularly challenging. One critical coverage issue that is sometimes overlooked in the dual capacity context is that to trigger coverage under most policies, an individual need only have been acting in an insured capacity – most policies do not require that the individual have been acting “solely” in an insured capacity. The problem then of course, if the individual is insured only to the extent he or she was acting in an insured capacity, is figuring out the extent of coverage. The fact that these kinds of disputes tend to be very fact-specific does not make them any easier to resolve.

Similar questions can also arise when a director or officer is also acting a director or officer of more than one entity or organization -- for example, where an individual is serving at the request of a private equity or venture capital firm on the board of a portfolio company. These concerns are among the many issues that may arise as a result of the interplay between the investment firm’s insurance and the portfolio company’s insurance, as discussed here.  

Many thanks to Aidan McCormick of DLA Piper for sending me a copy of the decision. DLA Piper represented the D&O insurer in this case.

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