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 discussed in a recent post (here), in a June 11, 2013 opinion, the New York Court of Appeals held that J.P Morgan (which had acquired Bear Stearns) is not barred from seeking insurance coverage for a $160 million portion of an SEC enforcement action settlement labeled as “disgorgement,” where Bear Stearns’ customers rather than Bear Stearns itself profited from the alleged misconduct. The Court of Appeals opinion can be found here.

In the following guest post, Peter Gillon of the Pillsbury law firm offers his views about the Court of Appeals opinion in the J.P Morgan case, as well as about the decision’s implications. Readers are encouraged to add their comments on Peter’s guest post using the comment feature in this blog’s right hand column. I would like to thank Peter for his willingness to publish his article on this site. I welcome guest posts from responsible commentators on topics of interest to this site’s readers. Please contact me directly if you are interested in publishing a guest post. Here is Peter’s guest post:

In a case closely watched by industry observers, the New York Court of Appeals, in J.P. Morgan Securities v. Vigilant Insurance Company, No. 113 (NY, June 13, 2013), issued an important ruling in the field of Directors & Officers Liability Insurance, curtailing to some extent insurers’ ability to use a phantom exclusion to deny coverage. Insurers increasingly have argued that their policies do not cover damages that can be characterized as restitutionary in nature, even where the policy may be silent on the issue. The contention is based on two theories: (1) that notwithstanding contract language providing coverage, the policy is unenforceable in that respect because in some states coverage for damages in the form of restitution (or disgorgement of ill-gotten gains) is unenforceable as a matter of public policy; and (2) from an economic standpoint, when a policyholder returns monies it has obtained improperly, there is no basis for coverage because the policyholder has not incurred any “Loss.”

The New York high court called foul on this encroachment on policyholders’ contractual rights, holding that policyholder Bear Stearns was entitled to pursue its claim to coverage for a $160 million payment incurred as a result of settlement of an SEC enforcement proceeding, even though the agreement expressly characterized the payment as “disgorgement.” As the Court made clear, there is no public policy in the State of New York barring coverage for restitution or disgorgement; and the limited public policy exception to the enforceability of contracts for “intentionally harmful conduct” could not be sustained by insurers on the record before the court. (Slip Op. at 9-11). More important to policyholders, the Court also held that the bulk of the payment characterized in the settlement agreement as “disgorgement” was actually compensation for profits improperly received by Bear Stearns’ hedge fund customers, not the result of gain by Bear Stearns. Given that the “policy rationale for precluding indemnity for disgorgement – to prevent the unjust enrichment of the insured by allowing it to, in effect, retain the ill-gotten gains by transferring the loss to its carrier,” was not implicated because Bear Stearns was “not pursuing recoupment for the turnover of its own improperly acquired profits,” the Court denied insurers’ motion to dismiss. As Justice Smith put it during oral argument before the appellate court, “how can you disgorge something that you haven’t ‘gorged’?”

The ruling is critically important in that it curtails the use of the unwritten “restitution defense” by D&O insurers subject to New York law, unless the restitution payments at issue corresponded to benefits actually received by the insured. Under this test, the restitution defense would not apply to any claim, such as a claim for breach of fiduciary duties by directors or officers, where the individuals did not receive the benefit of a distribution or other transaction. Likewise, this matching test should limit use of the restitution defense in response to Side B claims (reimbursing a company for amounts paid as indemnity to individual directors or officers), where the company has paid restitution to a third party, but individual directors or officers did not actually benefit from the funds being disgorged.

Left unaddressed by the New York court, however, is one of the nagging issues in this area: whether the restitution defense requires the insurer to prove not only that the insured was the actual beneficiary of the amount being disgorged, but also that the gains were “ill-gotten.” In many cases, the recipient actually earned the amounts being disgorged, lawfully and properly, but is required to turn over its gains for technical legal reasons, regardless of fault. This may occur in a fraudulent transfer action brought by a bankruptcy trustee under Section 548 of the Bankruptcy Code (allowing avoidance of certain types of payments, such as severance payments to executives, made by an insolvent company less than two years prior to the bankruptcy petition date, in return for less than reasonably equivalent value). At least one court has held that in a fraudulent transfer action brought by a debtor company’s bankruptcy trustee against the company’s former CEO, the employee severance payment the CEO was ordered to disgorge did not constitute “Loss” within the meaning of the D&O policy. In re Transtexas Gas Corp., 597 F.3d 298, 310 (5th Cir. 2010)(“Payments fraudulent as to creditors that must therefore be repaid due to bankruptcy court order [are] a disgorgement of ill-gotten gains and a restitutionary payment.”). Other courts have rejected such an approach as an overbroad application of vague notions of public policy. In Federal Ins. Co. v. Continental Casualty Co., 2006 WL 3386625 (W.D. Pa. Nov. 22, 2006), a case arising from an action to recover alleged fraudulent transfers to former directors and officers under the Bankruptcy Code, the court refused to find that public policy rendered the preferential transfers uninsurable under state law. The court recognized that because liability in a fraudulent transfer action is strict, without regard to fault, “allowing the insured to collect under its insurance policy would not encourage others to intentionally engage in unlawful activity with the purpose of reaping a benefit from such activity through its insurance.” Id. at 23. The court observed that the insurance company already had a safeguard in place to prevent the insureds from reaping a windfall, namely, the Illegal Profit Exclusion. Id. Thus the court properly refused to second guess an expressly stated term of the policy based on public policy arguments. 

In light of the J.P. Morgan ruling, insurers and insureds alike are well advised to take a fresh look at their policy wordings. The expanding use of the restitution defense, and the inherent difficulty in applying policy language to contractual terms such as restitution and disgorgement, strongly suggest that policyholders should demand clearer policy language. On the negative side, a few policies now expressly exclude restitution and disgorgement from the definition of Loss, without defining those terms. Some policies are silent and some exclude from Loss any damages that are uninsurable as a matter of state law. From a policyholder’s standpoint, it makes good sense to insist on coverage for restitution/disgorgement to the fullest extent insurable under the law, absent final adjudication that the disgorgement was to remedy illegal profit or criminal conduct. Even in the unlikely event that a state’s “public policy” would prohibit enforcement of such contracts, an insurer can surely stipulate in its policy that it will not assert that restitutionary damages are uninsurable unless there is a final adjudication of illegal profit or conduct. It is already widely accepted wording in almost every D&O policy (usually in the definition of “Loss”) that the insurer will not assert that (restitutionary) damages imposed under Sections 11 or 13 of the Securities Act are uninsurable as a matter of law; so this recommendation is in no way a “stretch.” Given the decade of litigation over these issues, for insurers to continue to assert this phantom exclusion instead of setting forth a clear statement in their policies is the real violation of public policy.

© Peter M. Gillon 2013

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By the time you read this blog post, you undoubtedly will have seen one of the stories in the mainstream media reporting on the February 25, 2013 decision of Southern District Court Jed Rakoff ordering former Goldman Sachs director Rajat Gupta to repay most of the legal fees the company incurred in connection with the government’s investigation and prosecution of Gupta. In case you didn’t see the stories, you can find them, for example, here and here.

There are a number of interesting things about Judge Rakoff’s order, many of which garnered little attention in the mainstream media reports.

By way of background, readers may want to recall that Gupta was convicted in June 2012 of leaking boardroom secrets to Raj Rajaratnam, who relied on the leaked non-public information in making highly profitable securities trades. Gupta was sentenced in October 2012. Gupta is appealing his conviction.

Judge Rakoff did not enter the order ordering Gupta to repay Goldman in a separate proceeding. Rather, Judge Rakoff entered the order in connection with the criminal proceeding against Gupta, and in particular as part of his (Rakoff’s) deferred determination of restitution in connection with Gupta’s sentencing. Goldman had specially appeared in Gupta’s criminal case to seek restitution of the $6.9 million in fees it paid to the Sullivan & Cromwell law firm in connection with the criminal case and related matters. (Goldman later withdrew a request for restitution of Gupta’s salary and for restitution of legal fees incurred in connection with a Section 16(b) short-swing profits proceeding against Gupta, which would explain why the amount Rakoff awarded was below the restitution amount Goldman had originally requested.)

Goldman sought restitution under the Mandatory Victims Restitutions Act, which mandates restitution in a criminal case where an identifiable victim has suffered a pecuniary loss. Under the Act, the restitution may include “necessary” expenses incurred during participation in the investigation or prosecution of the offense. Under Second Circuit authority, necessary other expenses may include attorneys’ fees, provided that the court finds by a preponderance of the evidence that the expenses were necessary and were incurred in connection with the investigation or prosecution of the offense, and that they were incurred by victims of the offense.

Goldman submitted 542 pages of its counsel’s billing records, relating to a range of related matters, not just Gupta’s criminal proceedings alone. Gupta had argued that the restitution, if any, should be limited to fees incurred in his prosecution. But Judge Rakoff interpreted the relief to which Goldman is entitled under the Act broadly. Judge Rakoff said that “this Court has no difficulty in concluding, by a preponderance of the evidence, that nearly all of the expenses Goldman Sachs here claims were the necessary, direct, and foreseeable result of the investigation and prosecution of Gupta’s offense.” 

Among other things, Rakoff included expenses incurred during Goldman Sachs’s internal investigation into Gupta’s conduct; the fees Goldman incurred to attend post-verdict proceedings in Gupta’s case; the fees the company incurred in the parallel SEC case against Gupta; and the fees the company incurred in connection with Rajaratnam’s criminal prosecution.

It is important to highlight the fact that in ordering Gupta to repay Goldman for the fees it incurred, Rakoff was interpreting and applying the Mandatory Victims Restitution Act. Rakoff’s order did not involve or relate to any interpretation or application of Gupta’s rights for advancement of indemnification of his attorney’s fees under Goldman’s by-laws or under applicable state law. I emphasize this fact because, following Gupta’s conviction, there has been discussion in the press of Goldman’s rights (if any) to seek recoupment from Gupta under applicable principles governing advancement or indemnification.

It remains an interesting question whether or not Goldman might have had the right (or would have had the right if Gupta’s conviction is affirmed) to seek to establish in a separate civil proceeding that it had a right of recoupment. But Goldman was not relying on its recoupment rights and Judge Rakoff did not order Gupta to pay Goldman in reliance upon principles of advancement or indemnification. Rather, he was applying the Mandatory Victims Restitution Act.

The fact that Rakoff was applying the Act is also important in connection with the question of what the ruling might mean in other cases. The ruling is only going to be relevant in other cases where a corporate official has been criminally convicted and where there is an identifiable victim that has suffered a pecuniary loss. Absent a conviction, there would be no grounds for restitution. A company seeking restitution of attorneys’ fees and other expenses would have to meet the Act’s other requirements as well. (It should be noted that Goldman is not the only company to have sought restitution of attorneys' fees from a former official convicted of a criminal offense; as discussed here, Morgan Stanley is seeking in a separate proceeding to recover millions it paid to and on behalf of Joseph Skowron, a former hedge fund manager for the company who plead guilty to insider trading.)

Although it does not appear to have been relevant in Gupta’s case, it is interesting to consider what subrogation rights a D&O insurer might have under the Act in the event of a criminal conviction. To the extent that the attorneys’ fees had been paid by an insurer, the insurer might take the position that it is subrogated to any victims’ restitution rights to which the company is entitled under the Act. Whether the insurer would be as successful casting itself as the victim in that situation is an issue the carrier would have to address.

Today’s Classic Rock Note:  (Hat Tip to The Meta Picture.com)

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An insurance broker’s settlement of claims for disgorgement of undisclosed contingent commissions does not represent covered loss under a combined lines professional liability insurance policy, according to a December 3, 2010 decision of the Illinois (Cook County) Circuit Court. A copy of the December 3 opinion can be found here.

Background

Aon Corporation was first sued in 1999 in a class action lawsuit brought on behalf of its customers who alleged the firm had acted improperly with respect to its receipt of certain contingent commissions from insurance carriers. This class action lawsuit came to be known as the Daniel action. Aon was also the subject of certain regulatory investigations from several states’ Attorneys General based on the same allegations.

As originally pled, the Daniel action sought damages as well as other relief. However, the Daniels action was amended multiple times. As ultimately pled, the Daniel action sought only a disgorgement into a constructive trust of the amounts allegedly improperly received.

On March 4, 2005, AON entered into a settlement with the Attorneys’ General in which it agreed to deposit $190 million into a fund to be paid to former clients of the firm. The agreement specified that the firm would not seek indemnification from its insurers for the funds paid in the settlement.

On March 9, 2005, AON entered a separate settlement in the Daniel action, in which the firm agreed to pay an additional $38 million. The Danies action was approved by the Court.

Aon sought indemnification from its insurers for the amounts paid in settlement of the Daniels case as well as defense expenses incurred in the Daniel case and the Attorneys General action.

Aon’s insurance program included a Combined Lines Policy which combined certain lines of professional liability insurance, including directors and officers liability insurance, errors and omissions insurance and other lines as well. The Combined Lines Policy insurance program consisted of a layer of primary insurance and multiple layers of excess insurance.

In August 2006, AON initiated an action in Illinois (Cook County) Circuit Court seeking a judicial declaration of coverage under the Combined Lines Policy for loss incurred in connection with the Daniels action and related matters. The parties filed cross motions seeking to establish whether or not the Danies settlement and the defense costs incurred in the Daniel and the Attorneys General actions represented covered loss under the Combined Lines Policy.

The December 3 Order

In arguing that there was no coverage under the Combined Lines Policy for the settlement and defense expenses, the carriers argued that "Loss" covered under the Policy does not include "disgorgement of an ‘ill-gotten’ gain, that is, money of property an insured allegedly had no right to receive in the first place." The insurers argued that the Daniel plaintiffs sought only a constructive trust, not individualized damages, making it clear "that they were seeking disgorgement as their only remedy." The carriers also argued that it would be against Illinois public policy to allow the firm to pay restitution or fund a constructive trust with insurance proceeds.

AON in turn argued that there were genuine issues of material fact whether or not the remedies the Daniel plaintiffs sought were restricted solely to restitution. AON argued further that even if the pleadings as amended sought only restitutionary relief, the original pleadings had sought damages, and therefore the firm was entitled to its costs of defending the original pleadings. AON also argued that there was a genuine issue of fact whether the Attorneys General actions sought only restitutionary relief.

In her December 3 opinion, Judge Kirie Kinnaird rejected AON’s arguments and held that the relief sought in the Daniel action was "restitutionary and not an insurable loss." Judge Kinnaird rejected the firm’s contention that it was entitled to the defense expenses incurred before the pleadings were amended to remove the damages allegations, since the ultimately operative complaint, and the one to which AON filed its motion to dismiss, sought only restitutionary relief.

Judge Kinnaird also rejected AON’s argument that because there had been no determination in the Daniel action that the contingent commissions were "ill-gotten," the commissions represented amounts the firm was entitled to receive, and therefore the Daniels settlement represented covered "Loss." Judge Kinnaird said:

Insurability does not depend on whether a claim has merit, but rather what the settled claim sought….This Court will not make a finding or determination of whether AON’s alleged actions in the Daniel litigation were "ill-gotten gains" or unlawful. The lawfulness of collecting contingent commissions was not at issue in the Daniel litigation and is not relevant here. It was the Daniel plaintiffs’ allegation that AON failed to disclose its eligibility to receive the contingent commissions and the retention thereof that gave rise to AON’s potential liability.

Finally, Judge Kinnaird held that the firm was not entitled to recover its expenses incurred in defending the Attorneys General actions because the matters were in the nature of disgorgement and restitution. Judge Kinnaird rejected AON’s argument that the way that the claims were characterized in the settlement documents altered this conclusion. Because the underlying claims were not covered, the expenses incurred in the defending the matters likewise were not covered.

Discussion

There is an extensive body of case law holding that D&O insurance does not cover disgorgement or amounts incurred that are restitutionary in nature. What makes this holding interesting is Judge Kinnaird’s express observation that the question of coverage for the amounts AON sought does not depend on whether or not the amounts themselves were "ill-gotten."

Rather, the Judge held, the question of coverage for the amounts sought depending solely on the fundamental nature of the relief sought. Because the relief sought in both the Daniel action and the Attorneys General action was fundamentally restitutionary in nature, there was no coverage under the policy at issue.

The part of Judge Kinnaird’s holding worth thinking about is the ruling with respect to defense expenses. I think most would accept that liability insurance can’t be used as a way for insured’s to finance their repayment of amounts that were not the insured’s in the first place. However, the determination of noncoverage for the amounts incurred in defending against wrongful acts may or may not be as obviously reasonable to many observers.

I would be interested in knowing readers’ thoughts on the defense expense question. I think there may be some difficult issues there to consider, especially with respect to individual defendants (particularly in the bankruptcy context).

Special thanks to a loyal reader for providing me with a copy of the AON decision.

SafeNet’s Excess Carrier’s Rescission Action to Go Forward: On December 7, 2010, Southern District of New York Judge Naomi Buchwald denied the motion to dismiss an action to determine whether or not there is coverage under SafeNet’s excess D&O insurance policy for the settlement of the company’s options backdating related securities class action lawsuit. A copy of the opinion can be found here.

The excess carrier’s action seeks to rescission. In her December 7 opinion, Judge Buchwald held that neither the underlying carrier nor individual directors and officers who had not been named as defendants in the rescission action were indispensible parties to the rescission action.

Judge Buchwald also rejected the argument that the rescission action was not yet ripe, because the primary policy had not yet been exhausted by payment. She held that the rescission action represented a ripe controversy notwithstanding the fact that the underlying limit had not been exhausted because the securities class action lawsuit settlement presented the "practical likelihood" that the excess limits would be called upon.

Semtech Options Backdating Securities Class Action Lawsuit Settles: On December 8, 2010, Semtech announced that it had settled what is one of the last remaining options backdating-related securities class action lawsuits. As reflected in Semtech’s December 8 press release, which can be found here, the case has settled for $20 million.

I have added the Semtech settlement to my running tally of options backdating related class action lawsuits, which can be accessed here.

According to data compiled by Adam Savett of the Claims Compensation Bureau, of the 39 options backdating related securities class action lawsuits, seven (or 18% were dismissed) and 31 have been settled or partially settled. The total value of all options backdating related securities class action lawsuit is $2.38 billion. The average settlement is $68.7 million, and the median settlement is $14 million. Savett’s data also reflects average and median insurer settlement contributions.

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