Within the space of just a few days, two federal appellate courts – the Fifth and Sixth Circuits – issued separate opinions consider D&O insurers’ obligations to advance defense expenses. The Fifth Circuit entered its March 15, 2010 decision in the high-profile Stanford Financial insurance coverage dispute. The Sixth Circuit’s March 11, 2010 opinion was entered in an insurance coverage dispute involving Abercrombie & Fitch and a rather unusual set of circumstances surrounding the company’s D&O insurance policies. The Sixth Circuit’s opinion was also accompanied by a rather spirited dissent. Both decisions are interesting and provide illuminating perspective on D&O policy interpretation.
The Fifth Circuit’s Stanford Financial Decision
The March 15 Opinion
The Fifth Circuit’s March 15, 2010 opinion (here) arises out of the expedited appeal of Stanford Financial’s D&O insurers to the January 26, 2010 opinion of Southern District of Texas Judge David Hittner entering a preliminary injunction prohibiting the insurers from "withholding payment" of defense expenses from four individuals (including Allan Stanford) who face SEC and criminal actions in connection with the Stanford Financial scandal. My prior discussion of Judge Hittner’s ruling can be found here.
Stanford Financial had $100 million D&O insurance. The primary policy contained a fraud exclusion which does not apply absent a "final adjudication" that the prohibited conduct had occurred. The policy also contains a "money laundering" exclusion, which the insurers contend precludes coverage. The money laundering exclusion specifies that it does not apply "until such time as it is determined that the alleged act or acts did in fact occur."
In its March 15 opinion, the Fifth Circuit considered whose determination of the facts this exclusionary provision requires. The court emphasized that the provision does not specify that the insurer was to make this determination. The court commented that "while there is nothing remarkable about an insurer reserving the right to make a unilateral coverage decision, it is equally unremarkable to require an insurer to be explicit when doing so, rather than leaving the reader to ponder the word ‘it’."
The Fifth Circuit also considered the wording contrast between the fraud exclusion, which requires a "final adjudication," and the money laundering exclusions "in fact" wording, and observed that the difference between the two exclusions’ wordings boils down to the judicial proceeding in which the determination is to be made. The "final adjudication" provision, the Fifth Circuit reasoned, requires the determination to be made in the underlying proceeding, but the money laundering exclusion’s "in fact" determination wording requires a judicial determination but allows that determination to be made in a separate proceeding such as a coverage action.
The Fifth Circuit also held, in contrast to Judge Hittner’s ruling at the district court level, that the evidence relevant to this determination is not limited to the "eight corners" of the insurance policy and the underlying complaint; rather, the policy’s terms expressly contemplate the consideration of "extrinsic evidence" in the determination of policy coverage.
The Fifth Circuit remanded the case to the district court, with the added proviso that a judge not involved in the underlying criminal proceedings should consider the insurance coverage issues. The remanded case will be the "collateral vehicle" in which coverage is to be determined.
In the interim, until the determination, the insurers are obligated to advance defense costs until the merits are resolved. To that extent, the Fifth Circuit affirmed the district court’s preliminary injunction enjoining the insurers from withholding payment of defense expenses until the judicial determination.
However, the determination cannot be "final" until the underlying proceeding is resolved, because "a determination of the facts on remand unfavorable to the executives would have to be reconsidered should the executives be cleared of all charges."
The money laundering exclusion in the Stanford Financial D&O insurance policy is an unusual provision not found in many D&O insurance policies, and the wording arguably also reflects an unusual and awkward formulation. As the Fifth Circuit said of its own work and of the policy, its construction "is a sensible construction of an awkwardly drafted instrument."
But the Fifth Circuit’s analysis represents more than just a detailed exposition of an awkwardly worded and atypical clause. Most D&O policies have conduct exclusions requiring "determinations" as a prerequisite to the exclusions’ application to a particular set of circumstances. The Fifth Circuit’s orderly analysis of the determination processes implied by various policy formulations will undoubtedly inform future judicial consideration of the "determination" language found in the more typical D&O policy exclusions.
In particular, the Fifth Circuit’s analysis implying a requirement of a judicial determination in the first instance, and precluding unilateral insurer determinations unless expressly provided for, will illuminate coverage analysis whenever these types of conduct exclusions are at issue.
And in the underlying cases, the individual defendants will have their defense expenses advanced, for now, on an interim basis, until there is a determination in the collateral coverage case, and subject to the outcome of the underlying proceedings. Depending on how all of these circumstances unfold, the coverage dispute could go on for a considerable time. For now at least the individuals will be able to fund their defenses.
The Sixth Circuit’s Abercrombie Opinion
The March 11 Decision
In its March 11, 2010 opinion in the Abercrombie & Fitch coverage action, the Sixth Circuit affirmed the district court’s determination that Abercrombie’s D&O insurer must advance defense expense incurred in connection with the underlying claim. The Sixth Circuit’s opinion can be found here.
The coverage dispute arose out of an unusual sequence of events. Abercrombie had been insured by a $10 million D&O insurance policy that expired on September 1, 2005 (hereafter, the predecessor policy). On September 2, 2005, Abercrombie and certain of its directors and officers were sued in a securities class action lawsuit. Subsequently derivative suits were also filed and an SEC investigation ensued. On September 30, 2005, Abercrombie exercised its right under the predecessor policy to purchase one-year extended reporting period coverage.
Abercrombie also purchased a successor D&O insurance policy with a different insurer with a policy period incepting on September 1, 2005. The successor policy was amended to specify that the successor policy is expressly excess to the predecessor policy for any claims made regarding acts occurring prior to September 1, 2005. The parties to the coverage dispute agree that if the successor policy lacked this excess provision, the predecessor and successor policies would both be primary and would pay loss for the claim (including defense expense) on a pro rata basis.
The predecessor insurer contended that in this deal shifting the burden to provide primary coverage exclusively to the predecessor insurer, Abercrombie violated the policy’s cooperation clause, which specifies that "in the event of a claim," the policyholder "will do nothing that will prejudice [the insurer’s] position or its potential or actual rights of recovery."
The Sixth Circuit rejected the predecessor insurer’s argument, holding that the "purpose" of the cooperation clause, including its "no prejudice" provision, was to "enumerate the parties’ respective rights and obligations when a claim was made against an insured," but it "does not address the parties’ rights and obligations when a policy has elapsed, a claim has been made against a (formerly) insured, and the insured is deciding whether to elect – and how to structure – extended insurance coverage."
The Sixth Circuit added that "there is nothing about" the cooperation clause that "prevents Abercrombie from making fiscally driven business decisions, even if such a decision is unanticipated by an existing or past insurer." The Sixth Circuit also adopted the district court’s statement that it is an "unreasonable interpretation" of the cooperation clause "to find that it requires Abercrombie to structure its insurance needs based not on its own needs and its own best interests, but rather to minimize the insurers’ potential exposure."
Judge Kethledge’s Dissent
Circuit Judge Raymond Kethledge dissented. He emphaszied that the successor policy incepted on September 1 and as originally written was primary, and in fact, Abercrombie first reported the September 2 claim to the successor insurer. Then on September 29, Abercrombie elected discovery coverage, which Judge Kethledge noted "seemed a strange thing to do," since the $820,000 extended reporting period coverage was seemingly duplicative of the coverage in place under the successor policy.
Abercrombie was, Judge Kethledge wrote, "behind the scenes" negotiating with the successor insurer, for the successor insurance to be excess to the predecessor insurer’s coverage. It was not until November 22, 2005 that the successor policy was endorsed to make the successor policy expressly excess.
The effect of these changes, Judge Kethledge noted, was "retroactively to foist" on the predecessor insurer "the entire burden of coverage for the claim up to the $10 million policy limit." The reason Abercrombie did that, and was willing to pay the $820,000 premium for the extended reporting period coverage, was that in exchange the successor insurer waived its $2 million retention for the securities claims and promised not to increase Abercrombie’s premium for the following renewal.
Judge Kethledge viewed these events as having "prejudiced" the predecessor insurer in violation of the "no prejudice" provision in the cooperation clause, because it extinguished the predecessor insurer’s right to collect half of the claims costs from the successor insurer. Judge Rutledge noted that the "very purpose" of Abercrombie’s post claim action was to "increase [the predecessor’s] liability by $5 million and to extinguish its contribution claim for that amount." Judge Rutledge found the no prejudice clause’s requirement that the policyholder "do nothing" to prejudice that predecessor to be unambiguous and to clearly govern these circumstances.
What makes this situation so awkward is that Abercrombie’s negotiations with the successor insurer took place after the claim arrived. The opinion is not sufficiently clear on this point, but it seems as if at the time of the September 1, 2005 renewal the successor insurer competed to move onto the account and then got smacked by a claim airmailed in the second day it was on the policy.
It isn’t clear who initiated the negotiations, but the successor insurer was bargaining to reduce its exposure to the walk in claim. Reading between the lines, the predecessor insurer’s gripe is not with Abercrombie but with the successor insurer, for (as Judge Kethledge put it) "foisting" the claim on the predecessor insurer.
The deal Abercrombie and the successor insurer struck clearly benefited both of them – the successor insurer reduced its claim expense (for a claim that was clearly made during its policy period), and Abercrombie was able to obtain valuable concessions.
I can certainly see why the predecessor insurer objected under these circumstances. The question is whether as a matter of contractual rights and duties (as opposed to more basic notions of fair play) the detrimental impact of the successor insurer’s deal with Abercrombie represents the kind of "prejudice" that violates the provisions of the cooperation clause.
On the one hand, as a result of the deal, the predecessor insurer was obligated to do nothing more than it was otherwise obligated to do under the extended reporting period coverage, which all agree that Abercrombie was entitled to purchase, even if it did so after the claim came in.
On the other hand, the predecessor insurer’s rights and obligations under its policy also include the right to proceed against alternative sources of recovery. Abercrombie’s entry into the deal with the successor insurer compromised the predecessor insurer’s rights and it did so after the claim had come in. You can certainly see the predecessor insurer’s argument that this violated the requirement that the policy "do nothing" after a claim to prejudice the predecessor insurer’s right of recovery.
The majority found that there is nothing in the policy to prevent Abercrombie from structuring its insurance according to its own interests. There is certainly nothing here to suggest that Abercrombie did anything to prejudice the underlying claim. Moreover, there is nothing about the "no prejudice" provision that requires a policyholder to subordinate its interests to those of the insurer, and that consideration seems particularly relevant after a policy’s expiration.
In the end we may all nod sympathetically in response to the plight of the predecessor insurer here. Our sympathetic nods, however, reflect the sentiment expressed in the words of Judge Keithridge’s dissent: "What is legal is sometimes different than what is right."
And Finally: "Cigarettes are very like weasels – perfectly harmless unless you put one in your mouth and try to set fire to it." Boothby Graffoe.