In a sweeping July 1, 2011 opinion in MBIA’s favor, the Second Circuit held that the company’s D&O insurance policies cover the investigative and special litigation expense the company incurred during a regulatory investigation of its accounting practices. This case had been closely watched in the D&O insurance community because of widespread carrier concerns over the district court’s coverage findings. The insurers had hoped for relief on appeal. But the Second Circuit’s decision, if anything, is even more expansive in favor of coverage than was the district court.  



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 insurance industry accounting practices. In November and December 2004, the SEC issued subpoenas to MBIA concerning "nontraditional products." The New York Attorney General also issued subpoenas in November and December 2004 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.


The investigation ultimately narrowed to three MBIA transactions. The first involved MBIA’s retroactive purchase of reinsurance on it guarantee of bonds issued by an Allegheny Health hospital group (knows as “AHERF”). The regulators latter contended that MBIA’s retroactive reinsurance purchase allowed MBIA to avoid recognizing a large ($170 mm) one-time loss. In the second transaction involving General Asset Holdings GP, the allegation was that MBIA transferred its risk of an investment loss to an MBIA subsidiary, allowing the parent company to avoid reporting the loss. The third transaction involved MBIA’s guarantee of securities US Airways issued to purchase aircraft. When US Airways went bankrupt, MBIA foreclosed on the aircraft, and treated the transaction as an “investment” rather than a “loss.”


In October 2005, MBIA submitted an offer of settlement to SEC. 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. The independent consultant found no wrongdoing in connection with the Capital Asset and US Airways transactions.


In addition to the regulatory investigations, the company, as nominal defendant, was also sued in two derivative lawsuits. Prior to filing the suits, the shareholder plaintiffs had sent demand letters to MBIA asking the board to file suit against the directors and officers for the alleged wrongdoing. The company organized a demand investigative committee (“DIC”) to investigate the demands, but the DIC failed to act within the statutory time limit. The shareholders then filed suit, as a result of which the company organized a Special Litigation Committee (“the SLC”). The SLC hired an outside law firm, which investigated the derivative lawsuit allegations. Following its investigation, the SLC determined that maintaining the lawsuits was not in the company’s interest and recommended that the derivative lawsuits be dismissed. The derivative suits ultimately were 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 agreed it was obligated to pay the costs associated with the SEC’s AHERF investigation and also its $200,000 sublimit for the DIC investigation. The primary insurer disputed that it was obliged to reimburse other amounts incurred. Specifically the primary insurer disputed that it was obligated to reimburse the costs associated with NYAG’s AHERF subpoena; the Capital Asset and US Airways transaction investigations; the SLC expenses; and the independent consultant’s expenses. The primary carrier reimbursed MBIA $6.4 million.


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.


In December 30, 2009 opinion (discussed here), District Judge Richard M. Berman held that the policies covered all of the investigative costs and the special litigation committee counsel’s expenses, but that they did not cover the independent consultant’s post-settlement investigation. The parties cross appealed.


The July 1 Second Circuit Opinion

In a 43-page July 1, 2011 opinion for a three-judge panel of the Second Circuit, Southern District of New York Chief Judge Loretta Preska (sitting by designation) affirmed the district court’s holdings finding coverage for the investigative expenses and for the special litigation committed expenses. However, the Second Circuit reversed the district court with respect to the independent consultant’s expenses, holding that the policies covered this category of expense as well. In short, the Second Circuit found for MBIA with respect to all items in dispute.


The insurers argued that NYAG’s AHERF subpoena did not represent a covered “Securities Claim” within the meaning of the primary policy. The primary policy defined a “Securities Claim,” inter alia, 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.”


The Second Circuit agreed with the district court’s “sensible intuition that a businessperson would view a subpoena as a ‘formal or informal investigative order’ based on the common understanding of these words,” adding that in any event a “subpoena is a ‘similar document’ to those listed the definition of a ‘Securities Claim’ because it is similar to other forms of investigative demands made by the regulators.” The Court rejected the insurer’s “crabbed view” that a subpoena is a “mere discovery device” that is “not even ‘similar’ to an investigative order.”  Rather, it is the “primary investigative implement in the NYAG’s toolshed.”


The coverage debate with respect to the Capital Asset and US Airways transactions was whether or not the transactions fell within scope of the SEC’s formal order and the NYAG’s AHERF subpoena. The insurers had argued that descriptive limitations in the formal order’s caption put these matters outside the scope of the SEC’s order and NYAG subpoena. The Second Circuit rejected this argument holding that the order “announced a broad but definite investigative scope that includes these transactions.” It reached a similar conclusion with respect to the NYAG subpoena.


In addition, the Second Circuit rejected the insurers’ arguments that because the investigative documents connected with these matters were produced voluntarily by oral request rather than by subpoena or other formal process, there was no coverage in connection with the related investigation. The Second Circuit found this argument “meritless” since the investigations were connected with the formal order. The Second Circuit added that “insurers cannot require that as an investigation proceeds, a company must suffer extra public relations damage to avail itself of overage.”


The Second Circuit also rejected the insurers’ argument that the SLC expenses were not covered. The insurers had argued that the SLC was “independent” of MBIA and therefore was not an insured person under the policy. The Second Circuit observed that “MBIA formed the SLC to determine MBIA’s response to this litigation, and the SLC decided to terminate the litigation. The SLC entered appearances for MBIA and filed motions to dismiss on it behalf in both the state and federal cases.” Because “the dismissal of the suits was MBIA’s decision, undertaken pursuant to the powers granted to MBIA under Connecticut law,” the Second Circuit rejected the insurers’ argument that the SLC was not an “Insured Person” under the policy.


The Second Circuit further  rejected the insurers’ argument that because the SLC was required by law to operate “independently” of MBIA, it took on a separate identity and operated separately from MBIA. The Second Circuit characterized this as “sleight of hand,” because “independent” in this context means “independence of judgment,” a “lack of conflict of interest.” The Court noted that “independence of judgment does not generate a new source of authority to terminate derivative litigation; that authority is still exercised by the corporation, which can only act through its agents.”


Similarly, the Second Circuit rejected the insurers’ attempt to rely on the $200,000 sublimited coverage for investigative costs. The Court found that this sublimit related solely to pre-litigation demands. However the SLC’s activities were, consistent with Connecticut law, post-litigation, as a result of which the operative policy provisions were the general policy provisions relating to litigated matters, rather than the narrow sublimit relating to pre-litigation demands.


Finally, the Second Circuit rejected the insurers’ argument that against coverage for the post-settlement consultant’s investigation expenses. In a highly fact-based analysis, the Court determined that the insurers had been given adequate notice of these expenses and that MBIA’s provision of information relating to these expenses had not violated any of its notice or settlement consent obligations under the policy.



The Second Circuit’s MBIA opinion is an important decision addressing many recurring D&O insurance coverage issues, Because of the Second Circuit’s reasoning and the breadth of its language, policyholders will undoubtedly seek to rely heavily on this opinion in connection with the perennial issues such as coverage for costs associated with responding to a subpoena and special litigation committee expenses.


The Second Circuit’s opinion largely mirrored the district court with respect to the issue of the policy’s coverage for costs associated with responding to the NYAG’s subpoena – although even there, policyholders may find the Second Circuit’s language useful.


But the Second Circuit’s reasoning on the question of coverage for the SLC expenses goes further than the district court did. Judge Berman had found coverage for the SLC’s outside counsel’s expenses largely because of his specific factual determination that the SLC’s counsel had appeared on behalf of MBIA to have the derivative suits dismissed. The Second Circuit’s logic was more basic, having to do with the fundamental character of the SLC and its relation to the company under Connecticut law. The Court’s rejection of the insurers’ argument that the SLC was “independent” of the company seems particularly critical.


Another aspect of the opinion that many policyholders may find helpful is the section where the Second Circuit found coverage for the company’s expenses incurred in voluntarily providing investigative material to the regulators. Companies are often fighting with carriers over whether there is coverage for voluntary or cooperative efforts, which are often undertaken in an effort to fend off more formal regulatory action. Insurers can expect to have quoted back to them frequently the Second Circuit’s words that “the insurers cannot require that as an investigation proceeds, a company must suffer public relations damage to avail itself of coverage a reasonable person would think was triggered by the initial investigation.”


From the carrier’s perspective, this is a very fact-specific opinion that in many ways is largely a reflection of the unusual circumstance that all of the investigation followed the SEC’s issuance of its very broad formal investigative order. Much of the coverage analysis, including for example the court’s discussion of coverage for the voluntarily produced information, is merely  a reflection of the fact that the disputed expenses arose  after the formal order of investigation.


The much more frequent dispute involves costs incurred before the issuance of a formal order of investigation, a circumstance that was not involved here.  In that respect, it is critical to note that as broad as the Second Circuit’s opinion is, the decision has nothing to say concerning the recurring question of policy coverage for expenses incurred in connection with an informal investigation.


In addition to being fact-specific, the Second Circuit’s analysis, particularly in connection with the SLC expenses, is very law-specific too, depending narrowly on the details of Connecticut corporate law. Carriers can be expected to argue when the laws of other jurisdictions are applicable, the Second Circuit’s determination in the MBIA case is inapplicable.


While there are ways that the carriers can try to narrow the application of the Second Circuit’s MBIA decision, the fact is that this decision is a strong one for policyholders. This may be one of those instances where the carriers, if they really didn’t intend to cover these things and really don’t want to cover these things, may have to go back and look at their policy language. But since the general marketplace trend recently has been toward increased investigative cost coverage, the carriers may find that they lack sufficient marketplace room to maneuver on these issues from a policy language standpoint.


UPDATE: Joe Monteleone has an interesting July 6, 2011 post about the SLC portion of the Second Circuit’s MBIA opinion on his The D&O E&O Monitor blog, here.


Same Name, Different Reference: I may be the only one that cares, but there is a Camaroonian soccer player named Stephane Mbia, who plays in the French top flight soccer league, League 1, for the Olympique de Marseille club.