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

One of the hottest current topics in the field of D&O insurance is the question of coverage for costs incurred in connection with regulatory investigations. As discussed in the following guest post from Paul Ferrillo, who is Of Counsel and a senior litigator in the Securities Litigation/Corporate Governance Group of Weil Gotshal & Manges, LLP, these issues are likelier to become even more important as the Dodd-Frank whistleblower rules go into effect.

I would like to thank Paul for his willingness to publish his article on this site. (Paul's article previsously appeared in Propery & Casualty 360.) I am interested in publishing guest posts from responsible commentators on topics of interest to readers of this blog. Please contact me directly if you are interested in submitting a guest post for consideration.

Here is Paul’s guest post:

            Though most in-house risk professionals and in –house corporate lawyers do not exactly relish the opportunity to review their company’s directors and officers (“D&O”) liability insurance policy, the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), coupled with an increasingly active regulatory environment, should cause all companies (especially smaller ones) to consider the scope and breath of their D&O policies. Particularly important under Dodd-Frank is whether and how their policies will cover internal corporate investigations caused by whistleblowers out to recover a bounty (10 to 30 percent) on potential penalties collected by the SEC in excess of $1 million. Should these sorts of complex internal investigations be covered under the Company’s pre-existing directors and officers liability insurance coverage? Here are the considerations, and here are some potential answers.

            Scope of D&O Coverage for Corporate Investigations – Then and Now

            Before we begin, its probably important to re-emphasize why this question is important. Simply put, corporate investigations set in motion by a whistleblower or regulatory authorities (SEC, DOJ, and/or the states attorney generals), can lead to a whole host of problems for a company and its directors and officers, including: (1) potential fines and penalties, (2) potential criminal repercussions for individuals who are accused of potential wrongdoing, and (3) follow-on civil litigation commenced by the plaintiff’s bar seeking to take advantage of potentially damaging facts that came to light as a result of the investigation.  It also goes without saying that internal corporate investigations are expensive to conduct, including not only the associated legal expenses, but also IT expenses as well, which are occasioned by the need to review email and other soft-copy documents that might be relevant to the investigation. A competently handled investigation where no wrongdoing is found may cause regulators to walk away satisfied that the company “did the right thing.” and will many times will add no fodder to the follow on civil litigation A poorly handled investigation can lead to disastrous consequences for all involved, especially the company who has to ultimately “foot the bill.”

            Prior to 2011, D&O coverage for certain categories of internal corporate investigations was relatively standard in most primary D&O policies. Individual directors and officers were generally covered (depending, of course, upon the primary carrier and policy form in question) for both informal inquiries and requests for information, and civil, criminal, administrative or regulatory investigations commenced by either the issuance of a Target Letter or Wells Notice, or after the service of a subpoena. The company was almost never covered, except when it was named (along with an individual directors and officer) in a “formal”[1] SEC investigation (and then only when the D&O policy at issue specifically allowed for such coverage). No coverage, at all, existed for the Company for responding to “informal” inquiries and requests for information from the SEC.

            The New Threat – More Investigations – More Risk – More Expense

            On May 25, 2011, the SEC adopted final rules implementing the whistleblower provisions of Dodd-Frank. Though these rules are somewhat complex, for the corporate risk professional they can be broken down as follows. Dodd-Frank provides that (1) an eligible individual (e.g. an employee of a company), (2) who “voluntarily” provides the SEC (3) with “original information” about a potential violation about a violation of the federal securities laws, (4) that ultimately leads to a “successful” enforcement action, (5) may be entitled to receive a cash award ranging from 10% to 30% of the total monetary sanctions, in excess of $1 million, recovered by the SEC in a civil or judicial action.[2]

            Importantly, despite the fact that the potential whistleblower might just have easily reported the potential wrongdoing through the company’s own internal reporting and compliance program, the whistleblower provisions of Dodd-Frank do not require him or her to first do so. Instead, the whistleblower may go directly to the SEC in order to be “first in line” to receive the potential bounty. The new rules enacted by the SEC do give the whistleblower an “incentive” to first report internally by (1) allowing him up to 120 days to report such information to the Commission after he or she first reports internally (and still retain her or her place in line to receive the bounty), and (2) allowing for the attribution to the whistleblower who first reports internally all subsequently reported information reported by the Company following its own internal investigation.

            These reporting provisions, along with the monetary incentives of Dodd-Frank present the company at issue with a number of potential challenges: (1) more internal investigations as a result of the clear financial incentives of employees and others to “blow the whistle” (in fact, there are reports already that the SEC has received an increased number of tips (often made with supporting documentation) since the passage of Dodd-Frank[3], (2) the potential need to quickly perform an internal investigation should the whistleblower report to the Company first (knowing that he or she has 120 days to report to the SEC). Indeed it may be in a company’s interest to self-report to the SEC before the SEC contacts it first, and/or (3) in any event, be ready to perform the investigation upon first contact with the SEC should the whistleblower choose to bypass internally reporting procedures.

            Corporate Investigations D&O Coverage Today

            Prior to 2011, companies generally had no insurance mechanism to cover a costly internal investigation triggered by a regulatory inquiry. Today that is not the case. One large insurer has created a stand-alone product that potentially covers a company for a wide variety of potential corporate investigations., whether triggered by internal reporting through a company’s internal compliance program (with subsequent self reporting of a potential securities law violation), or triggered by a direct formal or informal written or telephonic communication with the SEC requesting information, documents or interviews.[4] There are rumors that other companies will soon follow suit and provide similar, if not alternative products or solutions, to cover the costs of internal corporate investigations triggered by regulatory inquiries.

            A stand-alone corporate investigations D&O policy has a clear advantage for many companies seeking to insure for corporate investigations, and a compelling advantage from the stand-point of a director or officer of a public company. Since it is “stand-alone,” monies spent under an “investigations”  policy will not reduce the limits of the company’s pre-existing directors and officers insurance coverage. Simply put, separate dedicated limits for a corporate investigation is the best solution.

            If for cost reasons, a stand-alone product is not affordable, but a carrier agrees to attach or “blend” corporate investigations coverage directly into the primary directors and officers policy, the directors and officers should insist either (1) that company only purchase such coverage with a significant “sublimit,” (meaning that only a portion of the primary policy can be used for a corporate investigation), or (2) purchase much higher D&O limits from a “tower of insurance” perspective, knowing that “on any given Sunday” a complex investigation could eat up millions of dollars of the tower. For many companies, it may be a good idea to consult with an insurance broker or advisor that has a high degree of experience in insuring public companies, as they can often help inform and effectuate some of the corporate investigations D&O insurance strategies laid out above.

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In its sweeping July 1, 2011 opinion in the MBIA case, the Second Circuit addressed many of the D&O insurance coverage issues that are currently the most contentious. The opinion has occasioned much discussion and commentary in the D&O insurance industry. My blog post about the case can be found here.

In view of the ongoing discussion about the case, I am very pleased to be able to publish here as a guest post an article analyzing and commenting on the Second Circuit’s decision written by Richard Bortnick and Micah J. M. Knapp of the Cozen O’Connor law firm. Rick is also the co-author of the Cyberinquirer blog. Many thanks to Rick and Micah for their willingness to publish their article here.  I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly.

Here is Rick and Micah’s guest post:

In its July 1, 2011 opinion MBIA, Inc. v. Federal Ins. Co. and ACE American Ins. Co., 10-0355-cv (2d Cir. July 1, 2011), the U.S. Court of Appeals for the Second Circuit rejected Insurers Federal Insurance Company’s (Federal) and ACE American Insurance Company’s (ACE) (collectively, the Insurers) appeals seeking to reverse a Finding of coverage for (1) expenses associated with federal and state government investigations into the insured’s accounting practices, and (2) a special litigation committee formed to investigate the shareholder derivative suits that followed the agency scrutiny. In an analysis heavily influenced by the facts, the Second Circuit swept aside the Insurers’ arguments that their D&O policies did not cover expenses associated with what they argued were informal agency inquiries and investigations only loosely associated with written agency orders and subpoenas. The court also concluded that expenses incurred by the special litigation committee formed by the insured, MBIA, Inc. (MBIA), to investigate two derivative suits were “Defense Costs” covered under the Insurers’ D&O policies. On close scrutiny, however, the impact of the decision may be limited based on the particular policy language at issue and the facts of the case.

The Policies

MBIA provides financial guarantee insurance for government bonds or structured finance obligations – essentially guaranteeing that bond holders would be paid with respect to MBIA’s clients’ bonds. MBIA purchased $15 million in primary D&O insurance from Federal covering the period of February 15, 2004 through August 15, 2004. ACE issued $15 million in excess coverage that followed form to the Federal policy in all respects relevant to the lawsuit (collectively, the Policies). The Policies’ entity coverage section provided: “The Company shall pay on behalf of any Organization all Securities Loss for which it becomes legally obligated to pay on account of any Securities Claim first made against it during the Policy Period ….” The Policies further covered “Defense Costs” for “Securities Claims.” “Securities Claim” was defined as “a formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document” that “in whole or in part, is based upon, arises from or is in consequence of the purchase or sale of, or over to purchase or sell any securities issued by [MBIA].”

The Agency Investigations and MBIA’s Claim

In 2001, the SEC issued an Order Directing Private Investigation and initiated an investigation into potentially unlawful accounting practices in the insurance industry. The SEC targeted MBIA in November 2004 as part of that larger investigation, issuing subpoenas compelling the company to produce documents concerning transactions involving “non-traditional products” – products that could be used to “affect the timing or amount of revenue or expense recognized.” The New York attorney general (NYAG) followed suit, serving MBIA with similar subpoenas requesting similar documents in November and December 2004.

The federal and state investigations eventually focused on three separate MBIA transactions. In the first transaction, MBIA purchased reinsurance for its guarantee of bonds issued by a group of hospitals owned by the Allegheny Health, Education and Research Foundation (AHERF) after AHERF declared bankruptcy. The investigations sought to determine whether MBIA endeavored to disguise the impact of a $170 million loss from the transaction with AHERF.

In the summer of 2005, the SEC and NYAG began investigating two additional transactions. In the second such transaction, MBIA purchased an interest in Capital Asset Holdings GP, Inc. (Capital Asset), but soon found it necessary to provide additional, unanticipated funds to Capital Asset. MBIA made the payment through a subsidiary, thereby transferring the risk of the investment loss to the subsidiary and allegedly disguising a potential loss to the parent company. The third transaction involved MBIA’s guarantee of securities used to purchase airplanes for US Airways. MBIA foreclosed on the airplanes after US Airways declared bankruptcy and treated the transaction as an investment in airplanes rather than a loss. 

MBIA forwarded the agency subpoenas to the Insurers in May 2005, informing them that it was the target of state and federal investigations. MBIA asked for the Insurers’ consent to retain counsel. The Insurers denied that the subpoenas triggered coverage, but accepted the subpoenas as notice of a potential claim. MBIA hired counsel and responded to the agency inquiries.

The SEC and NYAG considered issuing additional subpoenas concerning the Capital Asset and US Airways transactions in the summer of 2005. Concerned about additional adverse publicity, MBIA requested that the agencies hold on issuing more subpoenas, and instead accept MBIA’s voluntary compliance with the agencies’ demands. The SEC and NYAG agreed and, thereafter, MBIA complied with the agencies’ informal, often oral, requests.

In October 2005, MBIA forwarded the agencies an over of settlement concerning the AHERF transaction investigation. That over included a payment of penalties and MBIA’s proposal to retain an independent consultant to analyze the Capital Asset and US Airways matters. MBIA notified the Insurers of the settlement discussions in September 2005 and met with Federal in October 2005. At the time, however, MBIA did not advise the Insurers of its proposal to hire an independent consultant. The SEC and NYAG finalized settlements with MBIA in January 2007 in accords substantially similar to MBIA’s October 2005 over. The independent consultant later exonerated MBIA of any wrongdoing in the Capital Asset and US Airways transactions.

MBIA’s shareholders followed the state and federal agency investigations with two derivative lawsuits. Upon receiving the shareholder plaintiffs’ presuit demand letters, MBIA formed a Demand Investigative Committee (DIC) – a committee of independent directors tasked with investigating the shareholders’ demand letter. The DIC retained an outside law firm, Dickstein Shapiro (Dickstein), to assist in the investigation. When the DIC failed to act on the shareholders’ derivative demand within the time allotted by Connecticut law, the shareholders filed suit. MBIA reconstituted the DIC as a Special Litigation Committee (SLC), which again employed Dickstein to aid in the investigation of the derivative suit allegations. The SLC concluded that the suits were not in the best interests of the company and, consistent with Connecticut law, moved to dismiss the complaints.

MBIA submitted a claim with the Insurers seeking costs associated with the agencies’ investigations of the three transactions, the cost of the independent consultant retained to investigate the Capital Asset and US Airways transactions, and expenses associated with the DIC and the SLC. Federal paid MBIA approximately $6.4 million out of its $15 million limit to cover losses from the SEC investigation of the AHERF transaction and related lawsuits. The payment included $200,000 for the DIC’s investigation of the shareholder plaintiffs’ presuit demand pursuant to the Federal policy’s derivative investigation coverage sublimit. Federal denied MBIA’s claim for losses associated with the NYAG investigation of the AHERF transaction, the SEC and NYAG investigations of the Capital Asset and US Airways transactions, the independent consultant, and the SLC. ACE denied that it had any obligation to pay for any of the losses based upon MBIA’s non-exhaustion of the primary policy.

The Motions for Summary Judgment and Appeal

MBIA filed suit against the Insurers on May 7, 2008, asserting three claims for breach of contract and seeking a declaratory judgment. MBIA and the Insurers cross-moved for summary judgment on MBIA’s claim for losses associated with the NYAG investigation of the AHERF transaction, the SEC and NYAG investigations of the Capital Asset and US Airways transactions, the independent consultant, and the SLC.

Judge Berman of the Southern District of New York granted in part and denied in part the parties’ cross-motions for summary judgment. On balance, however, the Southern District found in MBIA’s favor, holding that the Insurers owed coverage for the SEC and NYAG investigations of all three transactions, as well as for the expenses incurred by the SLC. The District Court determined that MBIA was not entitled to coverage for the costs associated with the independent consultant’s review of the Capital Asset and US Airways transactions because MBIA had not provided the Insurers with adequate notice of its intent to retain the consultant. The Insurers appealed and MBIA cross-appealed. 

The Insurers’ appeal challenged the District Court’s holdings that the Policies obligated the Insurers to cover losses associated with (1) the NYAG investigation of the AHERF transaction, (2) the SEC and NYAG investigations of the Capital Asset and US Airways transactions, and (3) the SLC. 

On the first issue, the Insurers argued that the NYAG subpoena was a “mere discovery device” that did not meet the Policies’ definition of “Securities Claim.” The Second Circuit disagreed, pointing out that a subpoena is the “primary investigative implement in the NYAG’s tool shed,” and that, at a minimum, it constituted a document similar to a “formal or informal investigative order,” which was within the definition of “Securities Claim.”

On the second issue, the Second Circuit rejected the Insurers’ argument that the SEC and NYAG investigations into the Capital Asset and US Airways transactions were not within the scope of the SEC’s formal order and the NYAG’s similar AHERF investigation. The court found that the language of the SEC order and NYAG subpoenas evidenced a “broad but definitive investigatory scope” that included all three of the questionable transactions. It further observed that the SEC and NYAG investigations of the Capital Asset and US Airways transactions were connected to the SEC’s formal order and the NYAG’s AHERF investigation, and rejected the Insurers’ argument that they were not obligated to cover MBIA’s expenses associated with its voluntary compliance with informal requests made in the course of those related investigations.

The Insurers’ main argument in support of its third issue on appeal was that the SLC costs were incurred solely by the SLC, and that the SLC was not an “insured person” under the Policies. The District Court found coverage for the SLC expenses primarily because the expenses at issue were owed to Dickstein, and Dickstein had entered its appearance on behalf of MBIA, a nominal defendant in the derivative suits. The District Court reasoned that because Dickstein represented MBIA in the derivative suits, Dickstein’s fees were covered “Defense Costs.” The District Court then suggested that the SLC expenses would have been covered even if the outside firm had not represented MBIA, because the SLC was not an entity independent of MBIA.

The Second Circuit broadened the District Court’s reasoning and concluded that the SLC expenses were covered “Defense Costs” because the SLC was part of MBIA. After a brief analysis of Connecticut law on how and through whom corporations operate, the Second Circuit proclaimed that MBIA directed or acted through the SLC when the latter moved to dismiss the derivative suits and, as a result, the SLC was an “insured person” under the Policies. Unlike the District Court, the Second Circuit did not mention, much less rely upon the fact that Dickstein represented both the SLC and MBIA in the derivative suit. The Second Circuit further rejected the Insurers’ arguments that coverage for the SLC would render superfluous the Policies’ sublimit for investigation costs, and that the SLC expenses were excluded from coverage by operation of exclusions within the Policies’ definition of “Loss.” The court found that the investigation sublimit only applied to presuit investigations, not costs related to derivative suits, and that the Insurers had failed to establish that any exclusions applied to MBIA’s claim for SLC expenses. 

Turning to MBIA’s cross-appeal, the court reversed the District Court’s ruling in the Insurers’ favor on the issue of coverage for costs associated with the independent consultant’s investigation of the Capital Asset and US Airways transactions. In a lengthy analysis reciting what and when MBIA reported to the Insurers, the court concluded that MBIA did not breach the Policies’ “right to associate” clause, because MBIA provided the insurers with sufficient notice of the settlement discussions with the SEC and NYAG “early enough in the process to allow the insurers to exercise their option to associate effectively.”

MBIA’s Affect on Future Claim Disputes

The Second Circuit’s opinion touches on two types of expenses commonly disputed in D&O claims, expenses incurred in responding to state or federal subpoenas and special litigation committee expenses associated with the investigation of allegations in derivative suits. The court accepted the policyholder’s arguments in support of coverage for both types of expenses. 

With respect to the first category of expenses, MBIA interprets “Securities Claims” broadly, supporting the assertion that coverage extends to expenses associated with an insured’s voluntary compliance with certain types of informal or quasi-formal agency investigations. Insureds undoubtedly will cite MBIA for the proposition that a company does not forfeit its D&O coverage when it volunteers to cooperate with investigative agency requests rather than await formal, legal proceedings and risk suffering potentially damaging publicity and harsher penalties. 

The court’s ruling on coverage for MBIA’s voluntary cooperation with investigators, however, cannot be universally applied without regard to the court’s view of the breadth of the investigations and the expansive language of the primary policy’s insuring agreement. Both factors may provide bases for distinguishing MBIA from other cases. In MBIA, the policy at issue broadly defined “Securities Claim” to include any “formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document.” A formal order of investigation and regulatory subpoenas already had been issued by both agencies before any voluntary compliance was offered or undertaken. Given the Federal policy’s expansive definition of “Securities Claim,” the Second Circuit had little difficulty concluding that coverage existed. This should be distinguished from situations involving voluntary disclosure in the absence of formal agency process or where a policy contains more limited language. 

The most significant aspect of the Second Circuit’s MBIA opinion is the seemingly blanket pronouncement that special litigation committee investigative costs incurred in response to a derivative suit are covered “Defense Costs.” That holding, however, relies on two questionable propositions: (1) that the SLC was an agent of, and acted at the behest of, MBIA, and (2) that the SLC’s actions were related to the defense of MBIA or insured directors.

On summary judgment, the District Court strained to find coverage for SLC expenses by noting that outside counsel retained by the SLC to investigate the shareholders’ claims also represented MBIA as a nominal defendant in the derivative lawsuits. After linking the SLC’s expenses to Dickstein’s representation of MBIA in the derivative suits, the District Court decreed that the SLC costs were, in fact, “Defense Costs.” 

The Second Circuit abandoned the District Court’s reliance on Dickstein’s representation of both the SLC and MBIA, determining instead that the SLC was not a separate entity from MBIA and was, therefore, an “insured person” under the Policy. The court’s analysis notwithstanding, there is no support for the proposition that MBIA directed the SLC. Rather, the SLC was comprised of independent directors uninvolved in wrongdoing alleged by the shareholder plaintiffs. Indeed, under Connecticut law, the SLC was required to operate independent of MBIA and its board in the SLC’s investigation of the derivative suits. The decision to dismiss the derivative suits was the SLC’s alone. MBIA did not, and legally could not, instruct the SLC to conclude that the derivative suit was not in the company’s best interest.

More importantly, the SLC did not act in the defense of MBIA or the insured directors and its expenses should not have been categorized as “Defense Costs.” The Second Circuit’s opinion provides no analysis on this point, concluding simply that “the costs incurred by the SLC in terminating the derivative litigation were covered ‘Defense Costs.’” But the very purpose of special litigation committees – to investigate allegations in shareholder derivative suits and determine whether the company should prosecute those claims against the defendant directors – is a corporate governance function. The board, through the SLC, has a fiduciary duty to investigate whether wrongdoing has occurred and whether to seek relief on behalf of the corporation. Thus, the SLC’s investigative costs should be covered here only to the extent of the Federal policy’s investigations sublimit. 

Moreover, costs for appearing in a lawsuit are not necessarily defense expenses. The SLC, after all, was not defending itself or the corporation. It was, in this case, seeking the termination of claims against other directors on grounds that it was not in the company’s interest to pursue those claims. This is the company’s right as the true owner of the claims being prosecuted. Simply because targeted directors avoided adverse claims as a result of the SLC’s investigation does not transform the SLC into a tool to defend target directors or defeat shareholder derivative claims. Had the SLC decided to take over the prosecution of the claims, also its right, no colorable argument for coverage could have been made. The Second Circuit overlooked this crucial analytical distinction.

MBIA is likely to be cited by policyholders both within and outside the Second Circuit in support of arguments for broad coverage with respect to agency investigations and Special Litigation Committee costs. Insurers need to be aware of the limitations of the Second Circuit’s reasoning and the factual idiosyncrasies of the case.

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Among the most frequently recurring and arguably most vexatious D&O insurance coverage issues are the questions of the carrier’s obligation under the policy for defense expenses incurred either in connection with an informal SEC investigation or an internal investigation.

In an October 15, 2010 summary judgment ruling in insurance coverage litigation involving Office Depot, Southern District of Florida Judge Kenneth Marra, applying Florida law, denied coverage for both of these categories of defense expense. Though the decision is a direct reflection of the specific facts involved and the particular policy language at issue, the ruling provides an interesting insight into these recurring issues.

Background

In June 2007, Office Depot was the subject of news report suggesting the company had improperly disclosed material information to securities analysts in violation of Sec. Regulation FD. In a July 17, 2007 letter, the SEC advised Office Depot it was "conducting an inquiry" to determine whether the securities laws had been violated, and requested certain information from Office Depot "on a voluntary basis." Office Depot opted to voluntarily cooperate by providing documents and making its employees and officers available for sworn testimony. On July 31, 2007, the SEC requested that Office Depot preserve the records of numerous employees and offices, which it identified by job title.

Office Depot forwarded the letter to its insurers. Office Depot’s primary insurer accepted the letter as a "Notice of Circumstances" that may give rise to a claim.

In addition, in July 2007, before it received the SEC’s informal inquiry, Office Depot received an internal whistleblower letter raising concerns relating to the timing of recognition of Office Depot’s vendor rebate funds. Office Depot self-reported the whistleblower allegations to the SEC, which expanded its inquiry to include the whistleblower allegations. The company’s audit committee conducted its own investigation of the allegations, retaining lawyers, accountants and consultants for those purposes. The internal investigation resulted in Office Depot’s restatement of its 2006 financial statements.

In November 2007, two shareholder derivative lawsuits and two securities class action lawsuits were filed against the company. The shareholder suits alleged misrepresentations in connection with the company’s financial reporting of vendor rebates. In January 2010, the defendants’ motions to dismiss the securities class action lawsuit were granted. The dismissal is now on appeal. The plaintiffs in the derivative lawsuits voluntarily dismissed those cases.

In January 2008, the SEC issued a formal "order directing private investigation" and during the course of 2008 subpoened the company and at least eight current and former Office Depot officers and directors, including several who previously voluntarily testified. The notice did not name any individuals as wrongdoers. In November and December 2009, the SEC issued Wells notices to three Office Depot officers. In December 2009, the company reached an undisclosed settlement with the SEC staff.

Office Depot requested reimbursement from its D&O insurers of the over $23 million the company had incurred in responding to the SEC, indemnifying individuals against defense expenses, and conducting an internal investigation of the whistleblower allegations.

The primary carrier acknowledged its obligation to reimburse Office Depot for defense costs incurred by officers and directors after having been served with SEC subpoenas and Wells notices, and for the costs incurred in the four securities lawsuits. However, the approximately $1.1 million of acknowledged expenses did not exceed the policy’s $2.5 million retention. The primary insurer denied coverage for the other expenses, and Office Depot filed an action alleging breach of contract and seeking a judicial declaration of coverage. Office Depot’s excess D&O insurer intervened the action.

The parties filed cross motions for summary judgment.

The October 15 Ruling

The insurers argued that there is no coverage for Office Depot’s costs incurred in voluntarily responding to the SEC’s investigation and for the costs of Office Depot’s internal investigation of the whistleblower allegations because the costs did not arise either because of a "Securities Claim" against Office Depot or a "Claim" against an insured director or officer. All policy references below refer to the language of the primary policy.

The policy’s definition of Securities Claim contains threshold language that excludes from the term "an administrative or regulatory proceeding against, or investigation of, an Organization." However, the definition contains a "carve back" which specifies that the term Securities Claim "shall include an administrative or regulatory proceeding against an Organization, but only if and only during the time that such proceeding is also commenced and continuously maintained against an Insured Person."

Judge Marra found it significant that the threshold language excluded coverage for "an administrative or regulatory proceeding against, or investigation of" an Organization, but the carve back preserving coverage refers only to "an administrative or regulatory proceeding" – and thus the carve back does not refer to "an investigation" as does the threshold language. Judge Marra concluded that "the carve-back clause does not restore coverage for ‘an investigation of’ the Organization"

Judge Marra also found the policy’s definition of "Claim" distinguishes between "a proceeding for relief" and an "investigation of an insured person," specifying that an investigation constitutes a "Claim" only once the insured person has been notified in writing that he or she may be a target or after service of a subpoena.

In addition, Judge Marra rejected Office Depot’s argument that the term "proceeding" was broad enough to encompass the SEC’s informal and formal investigation of Office Depot. In reaching this conclusion, Judge Marra referenced the policy’s distinction between "proceedings against" and "investigations of" insured persons and organizations. Judge Marra said this distinction can only be given "any meaning" by giving the term "proceeding" its "plan meaning," which he defined as "a formal legal action or hearing conducted in a court of law or some official tribunal."

Judge Marra concluded therefore that the company’s costs of voluntarily responding to the SEC do not represent "loss of the Organization arising from a Securities Claim."

Judge Marra also concluded that the voluntary, pre-subpoena costs incurred on behalf of the individual directors and officers were not incurred in connection with a "Claim." In reaching this conclusion he specifically referenced the trigger required to bring an "investigation" within the definition of "Claim."

Office Depot had argued further that the policy’s "relation back" language brought all of the pre-claim costs within coverage when the claims finally did emerge. Office Depot made this argument in reference to the language in the policy’s notice provisions which provide that when a policyholder provides a notice of circumstances that could give rise to a claim, and a claim subsequently arises, the claim relates back to the time of the original notice.

Judge Marra ruled that the "relation back" language pertained solely to the question of when a "Claim" is first made for purposes of determining the appropriate claims made policy period. The relation back language, Judge Marra said, "simply serves to identify the policy period in which the ‘subsequent Claim’ was made; it does not operate to expand the Policy definition of ‘Claim’ to absorb any allegations of wrongdoing which happen to be related or similar to the wrongdoing described in the insured’s original Notice of Circumstances."

Judge Marra also rejected Office Depot’s related argument that the November 2007 securities lawsuit "relate back" to provide coverage for the company’s internal investigation. The company had argued that because the subsequent lawsuits were "subsequent claim," the Policy’s "relation back" language brought under the Policy’s coverage all defenses expenses incurred from the date of the Notice of Circumstances.

Judge Marra said that even if the securities suits were "subsequent claims" that relate back for notice purposes to the date of the original notice of circumstances, "it does not follow that any pre-suit investigation costs which may have related to and benefitted the defense of those suits…are transformed into a covered ‘loss’ which ‘arises from’ that securities litigation."

Finally, Judge Marra held that the Policy’s definition of covered Loss does not include the costs of investigating potential or anticipated claims, rejecting Office Depot’s argument that those costs are "arising from" the defense of a claim. He found that the "arising from" phrase "connotes a sequential relationship" between the Claim and the Loss that "arises from it" – that is, Loss that "follow sequentially in time." He said that covered loss "does not include related pre-suit or pre-claim investigation costs, regardless of how ‘related’ or ‘beneficial’ those costs may have ultimately proved to be in defending against the claim which ultimately materialized." He added that "while these costs may well have reasonably been incurred in contemplation of anticipated or potential litigation, that is not enough to meet the Policy’s requirement that the ‘resulted solely from’ the investigation or defense of a Claim."

UPDATE: In a subsequent October 27, 2010 order (here), Judge Marra rejected Office Depot's further assertion, based on the prior order, that the company was entitled to insurnace payment for all costs the company incurred in responding to the SEC after November 5, 2007, the date on which the first of the shareholder lawsuits was filed.

In his October 27 order, Judge Marra said that volunarary SEC response costs the company incrred after the shareholder suit was filed "may have followed the securities lawsuit sequentially in time, they did not 'grow out of' or 'flow from' the subject lawsuits, and therefore did not 'arise from'" those suits. Judge Marra added that even though the comany incurred SEC response costs after the shareholder suit was filed, that "does not transform the post-suit SEC response costs into covered 'Loss" ... even though some of those response costs may have been related to or had utility in Office Depot's defense of the securities lawsuit."

Discussion

Judge Marra’s analysis and conclusions are a direct reflection of the specific language at issue in the Office Depot case, and his analysis might or might not produce the same or similar outcome under different policy language. He seemed particularly persuaded that Office Depot’s primary D&O policy draws a clear distinction in how the policy responds to "investigations" on the one hand and "proceedings" in the other.

That said, Judge Marra’s analysis is quite detailed and represents a very thorough examination of what policyholders are entitled to under the policy before an investigation ripens into a formal administrative or regulatory proceeding. The opinion also represents a detailed examination of what insurers are responsible for before a claim has been made under the Policy.

Insurers will undoubtedly welcome this decision and will attempt to rely on it in other cases. As a district court opinion, the decision has limited precedential value, but the insurers will seek to rely on the decision for its persuasive value. The extent to which other courts will follow Judge Marra necessarily will depend on the policy language at issue in the other cases. Indeed, Judge Marra himself rejected Office Depot’s attempt to rely on prior decisions in which courts had held that an "investigation" is a "proceeding," stating that the policies involved in those other cases involve different language.

Notwithstanding Judge Marra’s decision, policyholders will continue seek coverage for defense costs incurred in informal investigations and for internal investigation, particularly where distinctions in policy language would seem to justify a different outcome. The sheer dollar costs involved alone (see, e.g., Office Depot’s $23 million in expenditures) ensure that policyholders will continue to agitate on these issues.

Given the perennial nature of these issues, the question arises of what are the practical lessons of Judge Marra’s opinion. The most important lesson seems to be that the policy’s wordings of "Securities Claim" and "Claim" are very important and the specific wording used with relation both to "investigations" and "proceedings" can be critically important. A particularly important issue for insurance buyers and their advisors to keep in mind is that a court may differentiate "regulatory and administrative proceedings" on the one hand and "investigations" on the other hand, and it is critically important to analyze coverage with respect to these two sets of considerations separately.

One final note relates to Judge Marra’s analysis of whether pre-claim defense expenses may be said to be "arising from" a subsequent claim. Judge Marra reduced this analysis to a question of temporal relation, in effect concluding that any particular item of defense expense can only "arise from" a claim if it comes later in time. I am not sure this analysis takes into account all of the possibilities, In particular, there are occasions when defense expenses are incurred earlier that would inevitably have been incurred later, the argument being the expenses "would have been incurred in any event" and the fact that they were incurred prior is an accident of timing. Arguably, Judge Marra’s analysis is not (or perhaps fairly ought not to be) preclusive of this argument. (Please refer to the Update above for further on this point).

It is probably worth noting that there have been recent innovations introduced into the D&O insurance marketplace designed to try to provide coverage for certain preclaim expenses incurred by or on behalf of individual directors and officers. The most recent formulations would not address the pre-claim expenses or internal investigative expenses of the insured entity itself, but it would at least provide direct or reimbursement coverage for costs incurred by or on behalf of individuals before a "Claim" has emerged.

These issues surrounding informal inquiries and internal investigations raise many points of contention, and policyholders and their insurers will continue to struggle with these issues. It seems probable that insurers facing these disputes will attempt to rely on Judge Marra’s opinion.

Special thanks to Steve Brodie of the Carlton Fields law firm for providing me with a copy of Judge Marr’s opinion. The Carlton Fields firm represented the primary insurer in the coverage litigation.

For discussion of a recent decision in which a court held that there was coverage under a D&O insurance policy for investigative expenses of a special litigation committee, refer here.

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

Background

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

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

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

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

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

The December 30 Ruling

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

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

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

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

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

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

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

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

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

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

Discussion

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

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

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

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

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

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

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