One of the most closely followed recent case developments in the D&O insurance arena is the ruling in the CNL Hotels & Resorts case that a Section 11 settlement did not represent covered loss under a D&O insurance policy. As I noted in a recent post (here), on August 18, 2008, the CNL Hotels & Resorts holding was affirmed by the Eleventh Circuit. These developments have occasioned a great deal of discussion and commentary in the D&O insurance community.
Among the more noteworthy commentary on this topic is the analysis of the well-known and widely respected D&O insurance coverage attorney, Joe Monteleone of the Tressler, Soderstrom, Maloney & Preiss law firm. Joe’s commentary appeared in his firm’s August 2008 Specialty Lines Advisory (here, at page 2). As always, I found Joe’s analysis interesting, but I also found that I disagreed with him on a portion of his analysis.
Because I thought an exchange of views on these topics would be useful and perhaps even entertaining, I approached Joe to determine his willingness to engage in a colloquy on this topic to be reproduced on this site. Joe agreed, and our exchange follows below. First, I have quoted a portion of Joe’s article, which is followed by my comments on his article. Joe’s rebuttal appears after my comments.
Joe’s Article (Extract):
In his commentary, Joe wrote the following with respect to the CNL Hotels & Resorts case (and cases with similar holdings):
When you cover the entity for its Section 11 loss, you are in effect saying that your IPO was overpriced by perhaps tens of millions of dollars. While not saying that it is OK, what you are saying is we will let the insurer step in and pay that loss and the corporation can keep its ill-gotten gain. How is that any different than a company simply refusing to pay for goods it has ordered and then letting its insurer pay when it is sued for a breach of its contract to pay? Insurance may cover negligent and even reckless misconduct, but it should not cover crooked behavior.
In his article, Joe makes a number of valid and interesting points, particularly with respect to the history of these issues. However, underlying Joe’s legal analysis is a series of value judgments. It seems to me that these value judgments misapprehend several critical considerations. I have set out these critical considerations below. In doing so, I also recognize that courts may have disfavored several of my arguments; readers will judge for themselves whether it is legitimate for me to reference these judicially disfavored points here
The first important consideration is that while companies that are the target of Section 11 claims may be alleged to have made all sorts of misrepresentations or omissions, these allegations are virtually never put to the test of proof. The mere fact that plaintiffs allege that offering documents contained supposed misrepresentations does not mean that the offering proceeds were in fact "ill-gotten." These kinds of claims, like all claims, are compromised because of the burdens and expense of litigation and because few are willing to accept the risk of an adverse verdict.
Nor does the fact that substantial sums are paid to compromise these claims, in and of itself, mean that the defendants company’s IPO was overpriced, much less that the company engaged in "crooked behavior." These settlements take place after the company has experienced a significant stock price drop. Compromising claims in the context of significant market capitalization losses can prove costly, but entry into even a costly settlement is far different than a determination of culpability or wrongdoing.
But I have even deeper concerns beyond just the fact that a settlement does not in and of itself betoken that a company’s IPO was "overpriced" or that the company is improperly keeping "ill-gotten gains." The fact is that the use of heavily freighted words such as "ill-gotten" and "crooked" are fundamentally misplaced in connection with alleged corporate liability in a Section 11 claim.
Under well-established legal principles, corporations are said to be "strictly liable" under Section 11 for material misrepresentations and omissions in offering documents. There is no element of fraud or scienter required in a Section 11 claim, and indeed plaintiffs pleading claims under Section 11 now routinely state (as a means of averting onerous pleading requirements) that they are not alleging or averring fraud in relation to these claims. The point is that in general not even the plaintiffs asserting the claims against these companies allege that the companies engaged in "crooked behavior."
In his article, Joe concedes that insurance properly can be paid for behavior that is merely negligent or even for behavior that is reckless. How then is it appropriate to withhold insurance benefits from companies who can be found liable without any fault at all?
I know that the district court in the CNL Hotels & Resorts case said that the absence of fraud allegations in Section 11 claims represents "distinction without a difference." But the absence of allegations of knowing or reckless misconduct does matter, deeply. The use of acutely pejorative words – that are completely unwarranted given the strict liability standard for corporate liability under Section 11 — has the effect of demonizing the company and putting it the position of moral error. The danger is that it is easier to withhold insurance benefits from a "bad" company. The use of these morally freighted words not only inappropriately shapes the tone of the dialog but potentially enables an unjustified result.
Moreover, even if a Section 11 claimant should allege fraud or dishonesty, the typical D&O policy’s fraud exclusion ensures that insurers do not have to pay benefits for "crooked behavior." But here’s the thing about the fraud exclusion – at least as worded in most current policies, it is only triggered after an adjudication of fraud. The fraud exclusion is no barrier to the payment of insurance benefits to fund settlements of claims alleging fraud.
Indeed, insurance companies regularly fund Section 10(b) claim settlements, notwithstanding allegations of fraudulent misconduct. Surely Joe is not suggesting that insurers cannot properly fund Section 10(b) settlements? And if Section 10(b) settlements properly can be funded because there has been no adjudication of fraud, why can insurers withhold payment of insurance benefits from Section 11 benefits in the absence of an adjudication of fraud, merely because of unproven allegations of "ill-gotten gains" or even "crooked behavior"?
An August 25, 2008 New York Law Journal article by Joshua Sohn of the DLA Piper law firm entitled "Liable Until Proven Innocent" (here) decries the leniency of Section 11 and Section 12(a)(2) pleading requirements. Among other things, Sohn quotes the Supreme Court’s recent Twombley opinion to assert that lenient Section 11 and 12(a)(2) pleading standards will continue to "push cost-conscious defendants to settle even anemic cases."
The lenient pleading standards make IPO companies that experience sharp stock price drops likely targets for Section 11 claims. The leniency of the Section 11 liability standards also means that the lawsuits are likely to survive preliminary motions, leaving defendant companies few options other than settling. Because of this heightened susceptibility to dangerous litigation, companies about to conduct an IPO are particularly sensitive to the need for D&O insurance.
An IPO company is generally regarded as an attractive insurance prospect, and many insurers compete actively to write the insurance for IPO companies. The confounding thing is that insurers that actively competed for the business and voluntarily undertook to insure an IPO company would later contend that the most likely and most dangerous claim the company would face is uninsurable. Whether or not this coverage position makes the insurance agreement illusory, it certainly raises serious concerns about the utility of the insurance agreement.
It will be argued that public policy prohibits insurance for corporate Section 11 liability because the relief sought is restitutionary in nature. As a general matter, the determination of private contractual matters based on public policy grounds raises certain fundamental question about the sources and uses of law. One particular concern is that the supposed requirements of public policy lack a definite point of reference and could become simply a matter of perspective. The notion than insurance for Section 11 claims is against public policy is neither inherent nor absolute, and indeed is an issue on which pertinent parties take a point of view different than followed in recent case law.
The SEC’s perspective is particularly relevant to this public policy question. On the one hand, the SEC takes the position (here) that corporate indemnification for ’33 Act liabilities is "against public policy" and unenforceable. On the other hand, the SEC emphatically does not specify that insurance for ’33 Act liabilities is against public policy. To the contrary, the SEC expressly designates (here) as among the expenses that properly may be charged to the costs of a securities offering the premium charged for insurance "which insures or indemnifies directors or officers against any liability they may incur in connection with the registration, offering or sale of such securities."
The SEC’s public policy analysis distinguishes between the indemnification of Section 11 liability and the provision of insurance for Section 11 liabilities. The SEC’s statements suggest that in its view public policy does not prohibit the enforcement of policies insuring against Section 11 liability, by contrast to its indemnification.
If nothing else, the SEC’s views ought to suggest that what public policy dictates as far the insurability of Section 11 claims is neither self-evident nor universally held. All of which should raise serious concerns about using judicially declared principles of supposed public policy to determine private contractual rights.
It was a nearly universal reaction among both D&O underwriters and brokers that this line of case law produced a result that, while perhaps perfectly logical to an insurance lawyer, ran absolutely contrary to marketplace understanding and commercial expectations. It is worth considering that both underwriters (the ones who sell insurance) and brokers (the ones who procure insurance on behalf of insurance buyers) universally agree that D&O policies should cover these kinds of settlements.
In response to these concerns, the entire D&O insurance industry has taken steps, as quickly and as vigorously as any insurance-related industry has ever done anything, to try to insert policy language calculated to prevent lawyers from making arguments that while perhaps logical to the lawyers defy the expectations and understandings of the commercial marketplace. The marketplace understands that the compromise of disputed Section 11 claims in no way means that a company has engaged in "crooked behavior" and in fact represents the very contingency for which policyholders buy insurance.
Kevin’s repeated admonishments for my use of the term "crooked behavior" call to mind Judge Posner’s words in the Level 3 decision, a case that perhaps more than any other establishes the public policy rationale relied upon by the CNL Resorts courts.
An insured incurs no loss within the meaning of the insurance contract by being compelled to return property that it had stolen, even if a more polite word than ‘stolen’ is used to characterize the claim for the property’s return.
Taking a cue from Judge Posner, I should have refrained from use of the pejorative term "crooked", and I regret any possible inadvertently implied mischaracterization of the motive of the corporate issuer in CNL Resorts or other cases.
Nonetheless, I will now "politely" set forth a number of rebuttal points.
First, I believe the fact that the underlying CNL Resorts litigation, like many other similar litigations, concluded with a settlement and, hence, no evidentiary proof of ill-gotten gain, misses the point of these insurance coverage cases. Regardless of the culpability of the conduct, there could be no liability of the issuer unless the offering was in fact overpriced. To have an insurer pay the amount of the overpricing, rather than have the issuer disgorge it uninsured, results in an unentitled windfall to the issuer.
That being said, I share Kevin’s observation of the irony that in these cases of what is in essence strict liability there can be no insurance recovery, but yet insurers routinely pay to cover liabilities resulting from reckless conduct in other securities cases. Ironic, yes, but it is supportive of the point that culpability of conduct is not the issue.
Also, I would agree that in most of these cases that are disposed via settlement, the insurer cannot apply one or both of its "conduct exclusions", which with increasing frequency in today’s insurance market are written with requirements of a final adjudication in the underlying proceeding. That may hold true for both the dishonesty exclusion and that for personal profit. The latter would arguably apply to preclude coverage for these settlements, but for an adjudication requirement, and in addition to the uninsurability reasoning of the courts in applying the law and public policy.
By no means do these decisions render the insurance agreement illusory, because none of them have applied the uninsurability argument to the individual directors and officers defendants. Thus, in most cases, an allocation should result, but certainly not a complete absence of coverage for all defendants. Although the court in the SR International decision enunciated a public policy argument of having the insurers stand behind the way they market their policies, that was in the context of a dispute over coverage for an underwriter defendant. There is little argument that an underwriter does not receive the proceeds of the offering, and thus its settlement payment cannot be fairly characterized as a disgorgement of ill-gotten gain. Nevertheless, the public policy arguments in that decision give a degree of validity and support to those D&O insurers who have voluntarily attempted to underwrite around the issue by endorsement, notwithstanding what may be the law now in some jurisdictions.
I do not want to belabor the seeming contrast between the SEC’s views on indemnification vs. insurance, but I believe the SEC may well not be inclined to enforce an indemnification prohibition in a settlement context where arguably no Section 11 "liability" has been established.
Finally, I must raise a bit of skepticism at Kevin’s conclusion that insurance underwriters and brokers are in universal accord as to providing "full" coverage for a Section 11 settlement, and that the debate remains only an arcane one among the wonks in the insurance coverage bar. I cannot speak for any particular insurer on this, but it appears at least some were vigorously contesting this issue before the Eleventh Circuit until its decision last month in CNL Resorts. Yes, the endorsements and new policy language purporting to clarify and grant the coverage are frequently seen in today’s market (and, in full disclosure, I have even crafted some of the endorsements and policy language at the request of clients), but I remain reluctant to concede the approach is universal.
Afterword: Consistent with the rules of engagement that I established for this colloquy, Joe gets the last word, so I will offer no surrebuttal. I would like to thank Joe for his willingness to engage on this topic and to offer his views. I would also like to invite readers to chime in on the debate using the blog’s comment feature. (Please note that you can add a comment without providing identifying information, so it possible to add comments anonymously.)