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

As I have discussed in prior posts (refer here for example), one of the recurring D&O insurance coverage issues that has arisen in connection with the FDIC’s failed bank litigation is the question whether or not the FDIC’s claims as receiver for the failed bank against the bank’s former directors and officers trigger the D&O policy’s insured vs. insured exclusion. In a terse January 4, 2013 opinion (here), Northern District of Georgia Judge Robert L. Vining, Jr. held that, owing to the “multiple roles” in which the FDIC acts in pursuing claims against the former directors and officers of a failed bank, there is “ambiguity” on the question whether the FDIC’s lawsuit triggers the insured vs. insured exclusion.

Background

Omni National Bank of Atlanta Georgia failed on March 27, 2009 (refer here). The FDIC was appointed as receiver for the failed bank. On March 16, 2012, the FDIC initiated a lawsuit in the Northern District of Georgia against ten former directors and officers of the bank, asserting claims against the defendants for negligence and gross negligence in connection with the approval of certain loans on low-income residential properties.

The bank’s D&O insurer initiated a separate declaratory judgment action seeking a declaration that there is no coverage under the bank’s D&O policy for the FDIC’s claims against the bank’s former directors and officers.

The D&O insurer filed a motion for summary judgment the declaratory judgment action, on three grounds: first: the carrier argued that because the FDIC as receiver “steps into the shoes” of the failed bank, the FDIC’s claim represents a claim “by, on behalf of, or at the behest of, the Company,” and therefore is precluded from coverage under the policy’s insured vs. insured exclusion; second, that the losses the FDIC seeks to recover do not fall within the policy’s definition of “loss,” which includes the so-called “loan loss carve-out”; and third that the policy does not in any event provide coverage for wrongful acts alleged against the former directors and officers that took place after the policy’s expiration.

The January 4 Opinion

In his January 4, 2013 opinion, Judge Vining denied the carrier’s motion for summary judgment with on the first two grounds, but granted summary judgment with respect to the alleged wrongful acts that took place after the policy’s expiration.

In rejecting the insurer’s argument that coverage is precluded by the policy’s insured vs. insured exclusion, Judge Vining said that “it is unclear whether the FDIC-R’s claims are ‘by ‘or ‘on behalf of’ the failed bank.” He added that “it is unclear what exactly is encompassed by the phrase ‘steps into the shoes.” These “ambiguities” arise, Judge Vining found, “in part because the FDIC-R differs from other receivers or conservators that might step into the shoes of a failed or insolvent bank.”

Judge Vining then reviewed the FDIC’s authority under FIREEA to recover losses, and the fact that in recovering losses the FDIC has authority to act on behalf of the bank’s depositors, creditors and shareholders.  Judge Vining noted that “the FDIC-R has multiple roles.” Accordingly, he concluded that “the FDIC-R has show that some ambiguity exists in the insured versus insured exclusion,” and he denied the carrier’s motion for summary judgment in reliance on the exclusion.

Judge Vining also rejected the carrier’s motion for summary judgment based on the argument that the financial losses the FDIC sought to recover did not constitute covered loss under the policy. Judge Vining found that “ambiguity exists in the definition of ‘loss’” because the “loan loss carve-out” does not “clearly exempt tortious claims” which is “the basis” for the FDIC’s claims in the underlying D&O liability action.

Discussion

Although D&O insurers have raised the insured vs. insured exclusion as a defense to coverage in connection with a number of FDIC failed bank claims, Judge Vining’s ruling in the Omni National Bank is so far as I am aware only the second ruling in connection with the current failed bank wave in which a court has made a ruling regarding the applicability of the insured v. insured exclusion to an action brought by the FDIC in its capacity as a receiver for a failed bank.

As discussed here, in October 2012, District of Puerto Rico Judge Gustavo Gelpi denied the D&O insurer’s motion to dismiss the coverage action the FDIC had brought against the carrier under Puerto Rico’s direct action statute. The D&O carrier involved had sought to dismiss the suit on the grounds that the D&O policy’s insured vs. insured exclusion precluded coverage for the FDIC’s claims in its capacity of the failed Westernbank against the bank’s former directors and officers. Judge Gelpi declined to dismiss the action, noting that the FDIC has authority under FIRREA to act “on behalf of depositors, account holders, and a depleted insurance fund,” and therefore that “the FDIC’s role as a regulator sufficiently distinguishes it from those whom the parties intended to prevent from bringing claims under the Exclusion.”

In both cases, the respective judges held that the carriers were not entitled to a determination as a matter of law that the exclusion precluded coverage. Both Judge Gelpi in the prior case and Judge Vining here determined that the Insured vs. Insured did not preclude coverage as a matter of law because the FDIC has the authority under FIRREA to act on behalf of a variety of different constituencies. The FDIC as well as individual directors and officers seeking coverage under their bank’s D&O insurance policies undoubtedly will seek to rely on these rulings in order to try to fight other carrier’s attempts to assert the Insured vs. Insured exclusion as a defense to coverage.

The insurers, however, will likely contend that even if the FDIC is acting on behalf of these other constituencies in bringing the suit, it is first and foremost bringing the suit in its capacity as receiver for the failed bank, as that is the basis upon which it has any right to bring the claims in the first place. The insurers will further argue that the sole basis on which the FDIC has any right to assert the claims is because, by operation of the receivership, it is acting “in the right of” the failed bank, and therefore the preclusive language of the exclusion applies, notwithstanding the fact that the FDIC may have other purposes and motivations in bringing the action.

The carriers will further argue that the policy’s exclusion does not require, in order for the exclusion to apply, that the action be brought “solely” or “only” “in the right of” the Organization. The insurers will argue that because the action was brought “in the right of” the Organization, the exclusion applies notwithstanding the fact that in bringing the claim the FDIC was also action on behalf of other constituencies.

Though these rulings unquestionably are helpful for the FDIC and the individual directors and officers, it seems likely that these issues will continue to be litigated in other cases.

Special thanks to a loyal reader for providing me with a copy of Judge Vining’s January 4 Order.

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A significant side-effect from the current bank failure wave has been the FDIC’s assertion of claims against the former directors and officers of many of the failed banks. The FDIC’s claims have in turn raised significant questions of insurance coverage under many of the failed banks’ D&O insurance policies. As discussed in a prior post (here), one of the significant coverage issues that has come up is whether or not the claims of the FDIC, which it is asserting in its capacity as receiver for the failed banks, are precluded under the Insured vs. Insured exclusion found in most D&O insurance policies. (The Insured vs. Insured Exclusion is sometimes referred to as the I v I exclusion.)

In what is as far as I know the first decision on this issue as part of the coverage litigation arising out the current bank failure wave, the federal court in Puerto Rico has ruled that the I v I exclusion in the D&O insurance program of the failed Westernbank of Mayaguez, Puerto Rico does not preclude coverage for the FDIC’s claims against the failed bank’s former directors and officers. A copy of the court’s October 23, 2012 decision can be found here.

Regulators closed Westernbank on April 30, 2010, which according to the FDIC cost the insurance fund $4.25 billion. In October 2011, certain of the former Westernbank directors and officers had sued the bank's primary D&O insurer in state court in Puerto Rico (about which refer here). The FDIC as receiver for Westernbank moved to intervene in the state court action, and on December 30, 2011, removed the state court action to the District of Puerto Rico. On January 20, 2012, the FDIC filed its amended complaint in intervention, in which it named as defendants certain additional directors and officers,  and, in reliance on Puerto Rico’s direct action statute, the D&O insurers in the bank's D&O insurance program. A copy of the FDIC's amended complaint can be found here.

In its complaint, the FDIC, as Westernbank’s receiver, seeks recovery of over $176 million in damages from the former bank’s directors and officers as well as their conjugal partners, based on twenty-one alleged grossly negligent commercial real estate, construction and asset-based loans approved and administered from January 28, 2004 through November 19, 2009. In its complaint in intervention in the directors and officers coverage action against the bank’s D&O insurers, the FDIC seeks a judicial declaration that its claims against the directors and officers are covered under the policies. All of the defendants moved to dismiss the respective claims against them.

In his October 23 opinion and order, Judge Gustavo Gelpi denied all of the motions to dismiss. His rulings with respect to the D&O insurers’ motions to dismiss the coverage actions against them appear on pages 16 and following in the October 23 opinion.

The D&O insurers had moved to dismiss the coverage actions that had been filed against them in reliance on the I v I exclusion in the primary insurance policy. The exclusion provides that “The Insurer shall not be liable to make any payment for Loss in connection with any Claim made against an Insured …which is brought by, or on behalf of, an Organization or any Insured Person other than an Employee of an Organization, in any respect and whether or not collusive.” The insurers argued that as receiver for the failed Westernbank, the FDIC stood in the shoes of Westernbank, which is an insured under the policy, and therefore the FDIC’s claims against the failed bank’s directors and officers were precluded from coverage under the D&O insurance policies by operation of the I v I exclusion.

As Judge Gelpi noted in his opinion these same issues were raised and litigated in a number of cases during the S&L crisis two decades ago. And as Judge Gelpi also notes in his opinion, these prior courts had split on the question of whether or not a D&O insurance policy’s Insured vs. Insured Exclusion precludes coverage for claims brought by the FDIC in its capacity as receiver against a failed bank’s former directors and officers. In summarizing these cases, Judge Gelpi noted that the question of the applicability of the exclusion in this context “is ambiguous.”

Judge Gelpi then, “with these differences in mind,” turned to the “purposes of the exclusion, the complaint and the specific terms of the policy for guidance.” He noted that the “obvious purpose” of the exclusion is to protect against collusive law suits; however, he also noted that the exclusion itself on which the insurers sought to rely made the exclusion applicable to Insured vs. Insured claims “whether or not collusive.”

The question to which Judge Gelpi then turned is whether or not the FDIC’s claims against the former directors and officers of Westernbank were “brought by, on behalf of or in the right of, and Organization or any Insured Person.” Judge Gelpi noted that the policy defines the term “Organization” as the named entity, each subsidiary and debtors in bankruptcy proceedings. After citing these provisions, Judge Gelpi summarily concluded that “Accordingly, the court finds that the FDIC’s course of conduct does not run afoul of this provision.” In reliance on prior cases that had concluded that the I v I Exclusion “does not prelude the FDIC from seeking redress from the Insurers.” 

By way of further elaboration, Judge Gelpi noted that the FDIC is suing “on behalf of depositors, account holders, and a depleted insurance fund,” and therefore that “the FDIC’s role as a regulator sufficiently distinguishes it from those whom the parties intended to prevent from bringing claims under the Exclusion.”

Discussion

Judge Gelpi’s ruling in this case is a significant victory for the individual directors and officers who hoped to be able to rely on the D&O insurance policies in order to be able to defend themselves against the FDIC’s claims against them, as well as for the FDIC, which hopes to be able to recover the losses it claims from the D&O insurance policies.

As the first decision on this insurance coverage issue in connection with the current bank failure wave, Judge Gelpi’s ruling will also obviously be of great interest to other failed bank directors and officers who face FDIC claims and whose D&O insurance carriers have tried to deny coverage in reliance on their respective policies’ Insured vs. Insured Exclusions. But while Judge Gelpi’s decision unquestionably will be helpful to the directors and officers in the other cases, it is far from the final word on the subject.

For starters, the split of authority in the cases from S&L crisis era remains. As Judge Gelpi noted, the courts have gone both ways on these issues and the carriers undoubtedly will continue to attempt to rely on the cases holding that the Insured vs. Insured exclusion does preclude coverage for claims brought by the FDIC.

A further reason that Judge Gelpi’s decision is unlikely to provide the final word on the subject is that other courts may not find the logic on which Judge Gelpi relied as compelling as he did. Judge Gelpi does not, for example, appear to have even considered the question of whether or not an action by the FDIC in its capacity as receiver of a failed bank (and therefore in effect, “standing in the shoes of the failed bank”) is an action “in the right of” the Organization, within the language and meaning of the exclusion. Other courts may consider it important in considering the exclusion’s potential applicability to address this issue expressly, as Judge Gelpi’s opinion does not. These other courts, in more careful consideration of this issue, might also conclude that the FDIC asserting claims as a failed bank’s receiver is asserting claims “in the right of” the failed bank and therefore that the exclusion applies.

In support of his conclusion, Judge Gelpi also considered it important that the FDIC was not only suing in its capacity as receiver, but was also suing on behalf of “depositors, account holders, and a depleted insurance fund.” Indeed, many of the courts that had ruled during the S&L crisis era that the Insured vs. Insured exclusion did not preclude coverage for claims by the FDIC had made their decisions in reliance on the same or similar observations about the FDIC’s claims.

The insurers, however, will likely contend that even if the FDIC is acting on behalf of these other constituencies in bringing the suit, it is first and foremost bringing the suit in its capacity as receiver for the failed bank, as that is the basis upon which it has any right to bring the claims in the first place. The insurers will further argue that the sole basis on which the FDIC has any right to assert the claims is because, by operation of the receivership, it is acting “in the right of” the failed bank, and therefore the preclusive language of the exclusion applies, notwithstanding the fact that the FDIC may have other purposes and motivations in bringing the action. The policy’s exclusion does not require, in order for the exclusion to apply, that the action be brought “solely” or “only” “in the right of” the Organization. The insurers will argue that because the action was brought “in the right of” the Organization, the exclusion applies notwithstanding the fact that in bringing the claim the FDIC was also action on behalf of other constituencies.

All of which is a long way of saying that though the policyholders and the FDIC prevailed in this case, these issues are likely to continue to be litigated, and the split of cases we saw during the S&L crisis is likely to continue.

Very special thanks to the several readers who supplied me with copies of Judge Gulpi’s opinion.

Another Georgia Failed Bank Lawsuit: On October 23, 2012, the FDIC, as receiver for the failed United Security Bank of Sparta, Georgia filed its latest failed bank lawsuit. The complaint, which the FDIC filed in the Northern District of Georgia, can be found here.

United Security bank failed on November 6, 2009. The FDIC’s lawsuit as the bank’s receiver is filed against a single defendant, Pierce Neese, the bank’s former CEO and also a bank director. The FDIC’s complaint asserts claims of Negligence and Gross Negligence against Neese in connection with 16 loans made between November 10, 2005 and March 27, 2008, which the agency alleges caused damages to the bank of over $6.373 million.

An unusual feature of the FDIC’s complaint, and perhaps the explanation why there is only a singe defendant is the case, is the agency’s allegation that from 2002 until March 2006, Neese “was effectively the Bank’s senior credit officer and functioned as a ‘One-Man Bank.’” Even after the bank established itself as a three-person LLC at the direction of regulators, Neese “continued to function as the Bank’s ‘one-man’ LLC until the Bank failed. According to the complaint, the bank even had print advertisements stating, “Meet Our Loan Committee, Pierce Neese.” The FDIC alleges that by dominating and usurping the loan approval process, Neese rendered the usual lending controls ineffective.

The FDIC’s complaint against Neese is the latest that the FDIC has recently filed as banks that failed in 2009 approach the third year anniversary of their closure (about which refer here). The complaint is also is the 35^th lawsuit that the FDIC has filed as part of the current failed bank wave and the 17^th that the agency has filed so far in 2012. The FDIC’s lawsuit against Neese is also the tenth lawsuit the FDIC has filed in connection with a failed Georgia bank. Although Georgia has had more failed banks than any other state, the percentage of all failed bank lawsuit involving failed Georgia banks is even greater than the percentage of all bank failures involving Georgia banks. For now at least, it seems as if the regulators are focusing on Georgia more than other states.

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As I have previously noted (most recently here), the pace of filing of FDIC actions against directors and officers of failed banks has slowed considerably as 2012 has progressed. Indeed, there have only been two new FDIC failed bank lawsuits filed since May, and none at all since mid-July (even though the FDIC has each month continued to increase the number of authorized lawsuits, as reflected on the agency’s website, here).

While the FDIC has not filed any new failed bank lawsuits recently, that is not to say that the regulatory authorities have not been active. Specifically, on September 25, 2011, the SEC filed enforcement actions in the District of Nebraska against three former officers of the failed TierOne Bank of Lincoln, Nebraska, as well as against the son of one of the three officers. The SEC’s September 25, 2012 press release regarding the enforcement actions can be found here, and the SEC’s two complaints can be found here and here.

Banking regulators closed TierOne Bank on June 4, 2012 (refer here). The SEC alleges that prior to the closure, TierOne understated its loan losses  and misstated the value real estate the bank had repossessed. The SEC alleges that as a result of the bank’s expansion into “riskier types” of lending in Las Vegas and other high growth areas, and the resulting increase in problems loans, the Office of Thrift Supervision directed the bank to maintain higher capital ratios. The SEC alleges that in order to comply with these requirements, three TierOne officials – Gilbert Lundstrom, the bank’s Chairman and CEO; James Laphen, the bank’s President and COO; and Don Langford, the bank’s chief credit officer – disregarded information that collateral securing the bank’s loans and real estate the bank had repossessed were significantly overvalued. The SEC alleges that as a result the bank’s losses were understated by millions of dollars in multiple SEC filings.

The SEC further alleges that after the OTS required the bank to obtain new appraisals for the collateral and repossessed real estate, the bank disclosed more than $130 million in loan losses. The SEC alleges that had these losses been booked in the appropriate quarters, the bank would have missed the required capital ratios several quarters earlier. Following the announcement of the loan losses, its stock price dropped more than 70%

The SEC alleges that Lundstrom communicated inside information to his son about the bank’s intention to sell certain assets. With the benefit of this information, Lundstrom’s son was able to purchase TierOne stock and then later sell it at a profit.

The SEC has reached settlements with Lundstrom and with his son, and with Laphen. Lundstrom has agreed to pay a $500,921 penalty. Laphen has agreed to pay a $225,000 penalty. Lundstrom’s son has agreed to pay a $225,921 disgorgement plus a $225,921 penalty. The sole remaining defendant, Langfor, has not settled the charges and the case against him remains pending.

The SEC’s press release quotes SEC Enforcement Director Robert Khuzami as saying that the bank’s understatement of its loan losses had the effect of “concealing the bank’s deterioration from shareholders and regulators alike.” The SEC’s press release also expressly acknowledges the “cooperation” of the Office of the Comptroller of the Currency.

The SEC enforcement actions relating to TierOne Bank are not the first that the SEC has brought against in the wake of a bank closure as part of the current wave of bank failures. As noted here, in April 2012, the SEC filed a civil enforcement action against two former officers of the publicly traded holding company of the failed Franklin Bank. In addition, as noted previously (here, scroll down), in an October 11, 2011 complaint (here), the SEC filed a civil enforcement action against four former officers of UCBH Holdings, Inc., the holding company for United Commercial Bank, which failed in November 2009.

The SEC action against the former TierOne officials serve as a reminder that the former directors and officers of a failed bank face significant additional litigation threats beyond just the possibility of a civil action by the FDIC in its role as receiver of the failed bank. Where, as here, the failed institution or its holding company were publicly traded, the potential liability exposures include the possibility of an SEC enforcement action or even a securities class action lawsuit. Even though the penalty amounts the SEC sought in the enforcement actions would not be covered under a D&O policy, the costs associated with defending this type of enforcement action would likely be covered (assuming that D&O insurance coverage is in fact available). These costs erode the limits of liability of any applicable insurance, reducing the amount of insurance available for any other pending claims. All of which is a reminder of the strains that post-failure litigation can put on the D&O insurance resources of a failed bank.

Summary Judgment Denied in Failed Bank Coverage Suit: Readers may recall that in a prior post (here), I described an action that a D&O insurer had filed in the Eastern District of Michigan, seeking a judicial declaration that the policy the insurer had issued to the failed Michigan Heritage Bank did not provide coverage for the claims that the FDIC, as receiver for the failed bank, had filed against a former officer of the bank. The defendants in the insurer’s declaratory judgment action include both the FDIC and the former bank official that the FDIC has separately sued.

In its declaratory judgment action, the insurer contends that there is no coverage under its policy for the FDIC’s claim against the former bank officer, arguing that coverage is barred by the “insured vs. insured” exclusion” and that the financial loss alleged in the underling claim does not constitute loss under the policy. The insurer moved for summary judgment.

In a September 24, 2012 opinion and order (here), Eastern District of Michigan Judge Bernard Freidman denied without prejudice the insurer’s summary judgment motion. In opposing the summary judgment motion, the FDIC has argued that the motion was premature because the terms on which the carrier seeks to rely are ambiguous and because discovery is required to determine the meaning of the terms.

In denying the insurer’s motion, Judge Friedman said that “the FDIC has shown that some ambiguity exists in the insured vs. insured exemption [sic] due to the ‘security holder exception,’ the omission of a regulatory exclusion, and statements by plaintiff that regulatory suits, which might include the instant action are covered.”

Judge Friedman also found “the FDIC has shown that some ambiguity exists in the definition of ‘loss’ because the so-called ‘loan loss carve out’ does not clearly exemption tortious conduct.” Judge Friedman also cited the insurer’s marketing materials “which indicated that charged-off loan losses are covered not excluded.” Judge Friedman denied the summary judgment motion to permit discovery on specified issues.

Judge Friedman’s ruling in this case does not represent a determination on the merits. It does not represent a determination that the Insured vs. Insured exclusion does not apply to a claim by the FDIC as receiver of a failed bank against the former officials of the bank.

However, there may still be some significance to the fact that Judge Friedman did find “some ambiguity” in the provisions on which the insurer sought to rely to contest coverage. His determination in the regard depended in part on specific factual issues, pertaining in particular to the insurer’s marketing materials. Nevertheless, the ruling does represent to some extent a determination that the question of whether or not the Insured vs. Insured exclusion applies to an FDIC failed bank lawsuit may not be a strictly legal issue but could involve factual issues on which discovery is required. If this coverage question is a factual issue – if there is “some ambiguity” regarding the insured vs. insured exclusion -- it could complicate insurer’s efforts to rely on the exclusion in order to contest coverage for FDIC failed bank claims.

To be sure, there will likely be another round on the issue of the exclusion’s applicability following discovery. But having to go on to that later round at a minimum could mean that obtaining  the coverage determination might turn out to be more involved than might have initially seemed like it would be.

FDIC, Bank Officials Settle Failed Bank Lawsuit: According to press reports, the FDIC and certain former directors and officers of Heritage Community Bank of Glenwood, Illinois have reached a settlement of the failed bank litigation that the FDIC, as receiver for the bank, had filed against the former bank officials. Background regarding the FDIC's 2012 lawsuit can be found here. The press reports do not disclose the amount or terms of the settlement. The September 10, 2012 settlement stipulation that the parties filed with the court (a copy of which can be found here) does not disclose the terms or amount of the settlement.

A March 2012 memo by the Jones Day law firm  discussing the Heritage Community Bank case (among other things) can be found here.

FDIC Settles Failed Bank Insurance Coverage Action: A week after the parties to the Heritage Community Bank case filed their settlement stipulation, the parties tothe D&O insurance lawsuit pending in the DIstirct of Puerto Rico involving the failed Westernbank. also filed a stipulation of settlement. As discussed here (refer to the "Update" section in the body of the blog post), in January 2012, the FDIC intervened in an action that the holding company for Westernbank had filed against the bank's D&O insurance carriers. According to the parties' September 17, 2012 stipulation  (here), the FDIC and the carriers have reached a settlement. The terms of the settlement are not disclosed in the stipulation. UPDATE: A knowledgeable reader who wishes to remain anonymous advises as follow with respect to the Westerbank settlement: "That action actually hasn't settled. The parties to a parallel proceeding involving fidelity bonds issues by [two insurers] (who also are parties to the Westernbank/FDIC D&O coverage action) did apparently settle, and was confirmed by the motion to dismiss referenced in  your blog post. Very similiar parties, and they involve some of the same underlying loans that assertedly led to the failure of the bank. But the fight goes on in the D&O coverage litigation." 

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In a June 29, 2012 opinion (here), the Seventh Circuit, applying Illinois law, held that when the defendants in a lawsuit include both persons who are insureds under the defendant company’s D&O policy and persons are not insureds, the policy’s Insured vs. Insured exclusion does not preclude coverage for the entire lawsuit, but only the portion attributable to the claims brought by the non-insured person defendants. The extent of coverage available when the defendants include both insured persons and non-insureds is to be determined by the policy’s allocation provisions.

Background

The underlying claim (referred to as the “Miller action”) involves a lawsuit brought by five individuals against Strategic Capital Bancorp, Inc. (SCBI) and two of its officers. In their suit, the plaintiffs asserted claims for fraud, civil conspiracy for alleged violations of the Illinois Consumer Fraud and Deceptive Business Practices Act. Three of the plaintiffs in the Miller action are former SCBI directors and therefore qualify as “Insureds” under the SCBI D&O policy. The other two Miller action plaintiffs are not Insureds under the policy.

The SCBI D&O policy includes an exclusion (of a type found in most D&O policies, and usually referred to as an “Insured vs. Insured” exclusion) precluding coverage for “Loss on account of any Claim made against any Insured: …brought or maintained by or on behalf of any Insured or Company in any capacity.” The Policy also contained an allocation provision, specifying that when loss from a Claim incudes both “covered and uncovered matters” the amount “shall be allocated” between covered Loss and uncovered loss based upon the relative legal exposures of the parties to the covered and uncovered matters.”

SCBI submitted the Miller action as a claim under its D&O policy. The carrier denied coverage for the claim in reliance on the Insured vs. Insured exclusion. Coverage litigation ensued. The District Court ruled in favor of the carrier, holding that the “plain language” of the exclusion precludes coverage for civil proceedings “brought or maintained by any Insured.” SCBI appealed.

The June 29 Opinion

In an opinion written by Judge David Hamilton for a three judge panel, the Seventh Circuit affirmed in part and reversed in part the holding of the district court. The appellate court affirmed the district court to the extent the lower court had held that coverage under the policy for the claims brought by the three former directors was precluded by the Insured vs. Insured exclusion, but reversed the district court to the extent that the lower court had held that the exclusion also precluded coverage for the claims brought by the plaintiffs who were not Insureds. The Seventh Circuit, In reliance on its 1999 decision in the Level 3 Communications, Inc. v. Federal Insurance Co.  case (here)– which the Court said was “practically indistinguishable“ from this case -- held that there was coverage under the policy for the claims brought by the non-insureds, and that defense costs and any indemnity amounts would have to be allocated between covered Loss and uncovered loss using the policy’s allocation provisions.

In the Level 3 case, the Seventh Circuit had also addressed the question of the application of an Insured vs. Insured exclusion in a D&O policy to a claim that ultimately included both insured and noninsured claimants. Initially, the claimants in the underlying case had only consisted of non-insureds. However, six months after the underlying lawsuit had been commenced, an insured person joined as a plaintiff. The Seventh Circuit held in the Level 3 case that in that situation “the insurance contract requires allocation of covered and noncovered losses rather than barring all recovery because of the presence of an insured on the plaintiff’s side of the case.”

The D&O insurer in this case attempted to distinguish the Level 3 case based on two factual differences: timing and “majority rule.”   The carrier first argued that in the Level 3 case, the insured plaintiff did not join the underlying suit until six months after it was filed. The Seventh Circuit said that its ruling in Level 3 had not depended on the timing, and so rejected this attempt to distinguish the earlier case.

Second, the carrier argued, in reliance on what the appellate court described as a “counting noses” approach that coverage in a mixed claimant case like this should be based o n the number of insured plaintiffs or proportion of damages claimed by insured plaintiffs. The court said that this “proposed additional requirement for a majority of non-insureds claimants or dollars has no basis in the …policy language.”

The appellate court also noted that the carrier attempted to rely on the Eleventh Circuit’s 2005 opinion in the Sphinx International v. National Union Fire Insurance Co. case (here), which also involved a claim brought both by insured persons and noninsureds. In that case, a former director initiated a securities suit and then published a nationwide notice soliciting other shareholders to join the suit. The former director then amended his complaint to add the additional plaintiffs.  The Eleventh Circuit held that coverage was precluded for the entire suit based upon the company’s D&O policy’s Insured vs. Insured exclusion., which precluded coverage for loss arising from a Claim brought “By or at the behest of … any DIRECTOR or OFFICER … unless such claim is instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of any DIRECTOR OR OFFICER of the company.” The Eleventh Circuit had held that the director plaintiff had actively solicited the other plaintiffs, and therefore the exclusion precluded coverage for the entire claim.

The Seventh Circuit found the Sphinx decision to be distinguishable by its fact, including in particular with regard to the policy language involved in that case. The Seventh Circuit also noted that Sphinx itself had distinguished the Level 3 case because the policy language in the earlier case was “too dissimilar” to the language at issue in Sphinx “to be decisive.”

Discussion

One of the reasons carriers include Insured vs. Insured exclusions in their policies is that, in addition to avoiding collusive suits, the carriers don’t want to pick up coverage for corporate infighting. Internecine battles can be vexatious and often are not susceptible to resolution on a rational business basis. Given this justification for the inclusion of an Insured vs. Insured exclusion in the policy, I can see how the carriers would take the position that if any one of the plaintiffs is an insured person, the entire claim should be excluded. The argument would be the involvement of even one insured presents too great a risk that the carrier might be dragged into corporate infighting or persona score settling.

There may be something to this argument; the carrier did succeed in convincing the district court that the involvement of even one insured as a plaintiff – or more specifically, the involvement here of three insured persons among the five claimants  – is sufficient to preclude coverage for the whole claim.

The problem with this argument – that one insured person plaintiff “taints the entire suit,” as the appellate court put it-- is that it can lead to some hard questions. As the appellate court noted, the carrier here took this “proposed rule” to “its logical limit,” arguing that it should apply and control even if there were 99 plaintiffs who were not insureds and only one insured person plaintiff. The appellate court also noted that the carrier had argued that the rule should apply even if separate complaints by an insured person plaintiff and non-insured were consolidated, even if only for pretrial proceedings. These examples from the logical limits of the insurer’s argument proved to be more than the court could accept, leading the appellate court to follow a solution based on allocation of between covered Loss and uncovered loss.

For carriers that nonetheless believe that Insured vs. Insured exclusion should apply even if only one of many plaintiffs is an insured person will want to consider the Seventh Circuit’s analysis of the Sphinx International opinion. The more encompassing exclusionary language at issue in that case seems likelier to preclude coverage when claimants include both insured person plaintiffs and non-insureds, particularly where the insured person plaintiff is actively involved in t he litigation.

For all D&O insurance practitioners the potentially different claims outcome based on the differences between the exclusionary language at issue in the Sphinx International case and the language involved here underscores the critical importance of these differences in policy wordings. In particular, those of us who are involved in representing policyholders in the insurance purchasing process will want to play close attention to the language used in the Insured vs. Insured exclusion in prospective policies, in order to determine whether it more closely resembles the language at issue in the Sphinx International case or the language involved here.

It is probably worth noting one particular challenge the carrier faced on appeal in the Seventh Circuit. The three judge panel that heard this case included Judge Richard Posner. Judge Posner wrote the opinion in the Level 3 case. Given that fact, it was always going to be the case that the Level 3 decision was toing to loom large here.

For general background regarding the Insured vs. Insured exclusion, please refer here and, here (in the bankruptcy context) and here (in failed bank litigation).

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An inevitable part of the current wave of bank failures has been the FDIC’s filing of lawsuits against former directors and officers of the failed institutions. And though the FDIC’s initiation of this litigation has been gradual, the lawsuits have now started to accumulate in significant numbers. And just as this FDIC litigation was perhaps inevitable once the banks started to faile, so too it was also perhaps inevitable that the FDIC lawsuits would be accompanied by D&O insurance coverage litigation.

As discussed below, the failed bank insurance coverage lawsuits are now starting to arrive. If the initial cases are any indication, one of the main coverage battlegrounds will be the typical D&O insurance policy’s Insured vs. Insured exclusion. Specifically, the question will be whether the FDIC as receiver pursuing the failed bank’s claim against the bank’s former directors and officers is acting as an “insured” under the D&O policy so as to preclude coverage under the policy.

First up in this analysis is Michigan Heritage Bank of Farmington Hills, Michigan, which failed on August 29, 2009 (about which refer here). As discussed in greater detail here, on August 8, 2011, the FDIC, as the bank’s receiver, filed a lawsuits in the Eastern District of Michigan against a single former officer of the bank.

What followed next is that on November 1, 2011, Michigan Heritage’s D&O insurer filed an action in the Eastern District of Michigan seeking a judicial declaration that there is no coverage for the underlying lawsuit or for the bank officer’s defense expenses under the bank’s D&O policy. A copy of the insurer’s declaratory judgment complaint can be found here.

Among other things, the carrier seeks a judicial declaration that the policy’s Insured vs. Insured exclusion precludes coverage for the underlying lawsuit. The insurer’s argument is that as the bank’s receiver, the FDIC is asserting the bank’s own claims and is seeking to recover the bank’s losses. Therefore, the carrier contends, the FDIC’s lawsuit is a claim “by, on behalf of, or at the behest of” the bank, and as the bank and the defendant loan officer are both insureds under the policy, the policy’s Insured vs. Insured exclusion precludes coverage.

A very similar sequence has also followed with respect to Westernbank, of Mayaguez, Puerto Rico, which failed on April 30, 2010. As reflected here, on December 17, 2010, the FDIC, through its outside counsel, sent a letter to Westernbank’s D&O insurer asserting claims against the bank’s former directors and officers.

Westernbank’s directors and officers , in turn, on October 6, 2011, filed an action in local Puerto Rico court seeking judicial declaration that the FDIC’s claim is covered under the bank’s D&O policy. The complaint, which is in Spanish, can be found here. According to an October 14, 2011 press release from the direcrors and officers' counsel, the complaint seeks a judicial declaration with respect to “the controversial and critical question whether the FDIC-R can be deemed an insured under the Policy so as to excuse [the carrier] from providing coverage.”

Though these declaratory judgment actions have only just been filed, they are in many ways a vestige of an earlier time. As I discussed in a blog post way back in August 2008, when the current bank wave was only just starting to unfold, the question whether the Insured vs. Insured exclusion precluded coverage for claims by the FDIC as receiver against former directors and officers of failed banks was hotly contested during the S&L crisis. As I said in my earlier post, and as appears likely now, the Insured vs. Insured exclusion could be a critical part of the failed bank insurance coverage litigation during the current round of bank failures as well.  

During the S&L crisis, where the FDIC had its greatest success in overcoming the Insured vs. Insured exclusion was where it was able to argue successfully that the Insured vs. Insured exclusion precluded coverage only with respect to collusive lawsuits. Because it was able to show that its claims and lawsuits were fully adversarial, it was able to establish that the exclusion did not apply.

The FDIC was not uniformly successful in arguing that the exclusion only precluded collusive claims, and there has in fact been some intervening case law to the effect that the Insured vs. Insured exclusion applies even when the underlying claim is not collusive.

It will in any event be interesting to see how these coverage cases develop. The one thing that seems certain is that as the FDIC failed bank litigation continues to accumulate, so too will the related coverage litigations. Many of the related coverage suits likely will also involve these same Insured vs. Insured issues.

Another issue that is likely to be litigated in coverage cases arising out of FDIC failed bank litigation is the enforceabilty of the so-called Regulatory Exclusion, which when present in the D&O policy precludes coverage for claims brought by the FDIC and other regulators. Not all policies implicated in the bank failures have these exclusions, but where they are present they are likely to be relied upon by the carriers to contest coverage. It is probably worth noting that these issues were fully litigated during the S&L crisis and the courts generally found that the regulatory exclusion precluded coverge for FDIC claims. My prior blog post about the regulatory exclusion can be found here.

A good summary of the D&O insurance coverage issues involved in FDIC failed bank litigation can be found here.

Special thanks to the several loyal readers who sent me links to ths source documents referenced above.

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When an ex- Chairman, CEO and Director sues his former company, are the company’s defense expenses covered under its D&O insurance policy? According to the June 24, 2011 report and recommendation of Middle District of Tennessee Magistrate Judge John S. Bryant, applying Tennessee law, they are not. A copy of Magistrate Bryant’s report and recommendation can be found here.

In October 2009, David Resha, a current shareholder and former Chairman, CEO and director of American Security Bank & Trust Company, sued the company in Tennessee state court for alleged violations of law and fiduciary duty. Resha alleged that the company had violated its bylaws and asserted the right to inspect the company’s books and records. American Security is the sole named defendant in the action.

The company submitted the action as a claim to its D&O insurer, seeking reimbursement for its defense expenses. The carrier denied coverage for the claim and American Security filed an action against the carrier alleging breach of contract and bad faith and seeking a judicial declaration that all past and future expenses incurred in defending against Resha’s claim are covered.

The policy contained the standard D&O insurance agreements for nonindemnifiable loss (Side A coverage) protecting the individual directors and officers in the event indemnification is not available to them due to insolvency or legal prohibition, and for corporate reimbursement (Side B coverage), reimbursing  the company to the extent it does indemnify the individual directors and officers. At least as presented in the Magistrate Judge’s report and recommendation, the policy did not contain a separate insuring agreement providing coverage for the entity’s own losses (Side C coverage).

The policy defined the term “Claim” to mean a “civil proceeding commenced by the service of the complaint … instituted against an Insured Person or against the Company, coverage is granted to the Company.” 

Resha’s lawsuit named only American Security as defendant in the lawsuit. Due to the absence of an entity coverage insuring provision, there is no separate coverage for the company under American Security’s D&O insurance policy. The company nevertheless argued that the insurer should reimburse the company’s defense costs because the complaint asserts bad faith actions and breaches of fiduciary duty by American Security directors, and therefore “impliedly” asserts claims against the directors.

The Magistrate Judge rejected American Security’s arguments, holding that because Resha’s complaint did not name the directors as defendants, the action has not been “instituted against” them. He said that to find under these circumstances that Resha’s action was “instituted against” the directors, the court “would be required to find the words ‘instituted against’ to be ambiguous.” He said that ‘after considering the usual, natural, and ordinary meaning of these words, there is no ambiguity to be found and any premise to the contrary must be rejected.” He added that “to find otherwise would violate the intent of this D&O policy and effectively change it into a comprehensive corporate liability policy.”

The Magistrate Judge went on to hold that “to the extent that a claim has been made against the directors and officers of American Security in substance, though not in form,” the claim would be barred by the policy’s Insured vs. Insured exclusion, since Resha, as the company’s former CEO is an insured person under the policy.

American Security had tried to argue that because Resha was also a shareholder, his claim was in the nature of a derivative claim, and therefore his action fell within the exception to the Insured vs. Insured exclusion for derivative claims. Without deciding whether or not Resha’s action was a derivative claim, the Magistrate Judge concluded that the derivative claim exception to the Insured vs. Insured exclusion did not apply, because Resha’s action was not maintained “independently of, and totally without the participation of any Insured” as would be required in order for the derivative claim exception to the Insured vs. Insured exclusion to apply.

The Magistrate Judge recommended that the insurer’s motion to dismiss be granted and the complaint against it dismissed.

Discussion

Assuming that the description of American Security’s D&O insurance policy in Magistrate Judge Bryant’s report and recommendation is complete, its policy is somewhat unusual as most current D&O insurance policies include a so-called entity coverage insuring provision (Side C coverage) providing insurance for the entity’s own separate liability exposures. Subject to all of the typical policy’s terms and conditions, entity coverage does provide a form of corporate liability protection.

However, even if American Security’s D&O insurance policy had carried the typical entity coverage insuring provision, Resha’s claim would still have run afoul of the policy’s Insured vs. Insured exclusion, and indeed if anything the exclusion’s applicability would have been even more clear.

The inclusion of the Insured vs. Insured exclusion in the D&O insurance policy is usually explained as a way to avoid the provision of insurance coverage for “collusive” claims. But that is not the only reason the exclusion is there. It is also a means to avoid insurance for corporate “infighting” where company officials attempt to pursue their disputes and rivalries in Court. The requirement that a derivative claim must be independent and without the participation of an insured person in order for the exclusion’s coverage carve back for derivative claims to apply is just an illustration as the ways the typical exclusions seeks to avoid coverage for infighting type claims.

Although Magistrate Judge Bryant’s report and recommendation does not say, it seems possible that Resha’s action represents just such an example of corporate infighting. The report and recommendation does not explain why Resha no longer is Chairman, CEO and a director of the company, but his action alleging by law violations and seeking access to the company’s books and records sounds like part of an ongoing dispute after his departure from office. In any event, Resha’s claim is the kind for which most D&O insurance policy’s typically would not provide coverage.

For a more detailed discussion of the Insured v. Insured exclusion generally, refer here.

Morrison: Domestic Transaction in Other Securities?: In its June 2010 decision in the Morrison v. National Australia Bank case, the U.S. Supreme Court said that the Exchange Act applies only to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.” Among other issues with which the lower courts have struggled in the wake of Morrison has been the reach of Morrison’s second-prong; that is, what are “domestic transactions in other securities?”

A July 8, 2011 decision by the Eleventh Circuit may shed at least a little bit of light on this question. The case, styled as Quail Cruise Ship Management Ltd. V. Agencia de Viagens CVC Tur Limitada, which can be found here, involved the sale of M/V Pacific, a boat once featured in The Love Boat television series. The sale was effected by a transfer of shares.  The buyer alleged that it had been induced to purchase the shares through a series of misrepresentations, in violation of the U.S. securities laws.

The district court had concluded that it did not have jurisdiction over the dispute because the shares were not listed on a U.S. exchange (the Eleventh Circuit correctly noted that the issue was not jurisdictional at all, but was rather under Morrison a question as to whether or not the U.S. securities laws applied).

The Eleventh Circuit held that because the complaint alleged that "the acquisition of the Templeton stock closed in Miami, Florida, on June 10, 2008, by means of the parties submitting the stock transfer documents by express courier into this District," the Complaint at least alleged that the final act to effect the share transfer took place in the U.S. Of course, whether or not the share transfer actually took place in the United States and whether the transfer actually effected the sale of the ship are questions of fact for later determination. 

Accordingly, the Eleventh Circuit held that it “cannot say at this stage in the proceedings that the alleged transfer of title to the shares in the United States lies beyond § 10(b)’s territorial reach.” the Eleventh Circuit vacated the district court’s dismissal and remanded the case for further proceedings. 

A further discussion of this case can be found in a July 15, 2011 post on the Corporate and Financial Weekly Digest blog, here.

The Message is Getting Through in China, Too -- At Least to a Certain Extent: In numerous posts on this blog, most recently here, I have noted the increasingly challenging D&O insurance market for U.S.-listed Chinese companies. The word about the challenging insurance market for these firms apparently is getting heard in China, too, at least based on one recent article. On June 24, 2011, the People’s Daily Online (English edition) carried an article entitled “D&O Premiums Skyrocket After U.S. Lawsuits” (here).

Although it is good that this message is getting communicated in China, the article soft-pedals the problem. D&O insurance premiums for U.S.-listed Chinese companies have gone up much more than the 20% increase cited in the article – that is, if you can find coverage at all. The article does at least go on to note, with greater (but not yet complete) accuracy, that in some cases the premiums have doubled. The premium increases have in fact been even more dramatic than that.

“Starring Your Love Boat Crew”: Those of you interested in having a look at the M/V Pacific or who just want a short trip down memory lane will want to view this video clip of the opening credits from The Love Boat, which according to Wikipedia, aired on television from 1977 to 1986.

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In a June 30, 2010 opinion (here), a three-judge panel of the Second Circuit reversed the lower court’s ruling that coverage under a directors and officers liability insurance policy for an underlying claim was precluded by the policy’s "insured vs. insured" exclusion, holding that the D&O policy at issue was "ambiguous" under Virginia law.

Background

Prior to May 2004, Community Research Associates, an Illinois corporation, was controlled by three shareholders, referred to in the coverage action as the Legacy Shareholders. In May 2004, CRA was reorganized as a Delaware corporation as part of a stock purchase agreement by which Sterling Investment Partners became the majority shareholder, and the Legacy Shareholders became minority shareholders. The pre-transaction entity was referred to in the coverage litigation as CRA-Illinois and post-transaction entity was referred to as CRA-Delaware.

The May 2004 transaction contemplated several events occurring simultaneously at the time of the transaction closing. Among other things, the Legacy Shareholders were to assume positions as officers or directors of CRA-Delaware in order to sign the paperwork to complete the reorganization plan. In addition, as a condition of closing, the Legacy Shareholders were required to resign their positions as directors of CRA-Delaware in order to close the merger.

In October 2004, CRA-Delaware purchased D&O Insurance policy. In its application for insurance, CRA-Delaware stated, among other things:

On May 3, 2004, the company had a merger with an investment entity. A new Chairman and Chief Executive Officer was installed. The prior ownership remained in a minority capacity but were no longer participants on the Board or officers of the corporation. On August 2, 2004 a new Chief Financial Officer was hired.

In August 2005, CRA-Delaware approved a merger whereby all of CRA-Delaware’s stock was sold to a third-party, CRA Acquisitions Corp. The Legacy Shareholders filed a lawsuit against certain directors and officers of CRA-Delaware, alleging a breach of fiduciary duty in connection with the August 2005 merger. The breach of fiduciary duty action ultimately settled for $3 million.

The CRA-Delaware directors who were sued in the breach of fiduciary duty action filed a claim under the company’s D&O insurance policy for the losses incurred in connection with the claim. The D&O insurer denied coverage for the claim in reliance on the policy’s "insured vs. insured" exclusion, and coverage litigation ensued.

The district court in the coverage action granted the carrier’s motion for summary judgment, holding that the "insured vs. insured" exclusion was unambiguous and that because the Legacy Shareholders were all former directors and officers of CRA-Delaware, having assumed those roles briefly in order to effectuate the merger, the losses from their claim fell within the Policy’s exclusion.

The Second Circuit’s Opinion

The Second Circuit first found that when the district court had concluded that the Legacy Shareholders "briefly assumed" the role of directors of CRA-Delaware in order to effectuate the merger, the district court "assumed[ed] the answer without addressing the parties’ argument."

The coverage claimants argued that CRA-Delaware "did not exist as an entity until after the closing of the merger." The Second Circuit said that "at the very least, the question should have gone to a jury to determine whether CRA-Delaware existed prior to the merger or, if it did, whether it was the same entity that existed after the merger for purposes of policy coverage."

In reaching this conclusion the Second Circuit, referenced CRA-Delaware’s policy application, which was attached to and, by the Policy’s terms, incorporated into the policy. The Second Circuit found that the application, which the Court emphasized was part of the policy, described the May 2004 transaction in a way that raised these questions about when CRA-Delaware came into existence, and in particular about whether the Legacy Shareholders were ever officers or directors of CRA-Delaware as such.

Citing Virginia law, the Second Circuit held that "the Policy, when read in its entirety, can reasonably be ‘understood in more than one way’ and is thus ambiguous." Both of the parties’ interpretations of when CRA-Delaware came into existence "rely only on language of the Policy and are reasonable in light of the various provisions of the Policy."

Accordingly, the Second Circuit remanded the case to the district court "to undertake any additional fact finding to interpret the Policy provisions in light of the facts to be found."

Discussion

At first impression, this case is a bit of head-scratcher, since the record does seem to suggest that the Legacy Shareholders were briefly directors of CRA-Delaware in order to effectuate the merger, which is exactly what the district court found.

On further reflection, however, the question may not be quite as straightforward as the first impression might suggest. There is a question about exactly when CRA-Delaware first came into existence, and whether the Legacy Shareholders were ever directors of CRA-Delaware when it came into existence. The application itself, which was incorporated in to the policy, seemingly suggests that the Legacy Shareholders were not officers or directors of CRA-Delaware as such.

Significantly, the Second Circuit did not affirmatively say that there was coverage here under the D&O policy, only that further findings of fact were required before it could be determined whether or not the insured vs. insured exclusion applied.

At some level, this coverage dispute may simply be a reflection of a very specific and arguably unique set of facts. However, the parties’ dispute is a reminder of the complexities that can sometimes arise in connection with the application of the "insured vs. insured" exclusion, which is frequently the source of contentious coverage issues.

That said, I don’t think the Second Circuit was saying the insured vs. insured clause in and of itself was ambiguous. Rather, the finding of ambiguity turned on the fact that the policy application was incorporated into the Policy – that is, by the Policy’s terms, the application was a part of the policy. The finding of ambiguity related to the interaction between the application as part of the policy and the insured vs. insured exclusion. In essence, the Second Circuit said that because of the ambiguous relation between these two parts of the policy, further fact finding is required.

My prior posts on the Insured vs. Insured exclusion can be found here and here.

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