When corporate officials face an SEC enforcement action, the testimony of non-party corporate employees is sometimes required. The insurance question that may arise when this happens is whether the attorneys’ fees incurred in connection with these witnesses’ testimony is covered under the company’s D&O policy. According to an interesting August 15, 2011 decision from the Southern District of California and applying California law (here), the employee witnesses’ attorneys’ fees are covered under the specific language of the D&O policies  involved.



Three individual officers of Gateway, Inc. were the subject of an SEC enforcement action. During the course of the SEC action, certain of Gateway’s current and former employees who were not parties to the SEC lawsuit were compelled by subpoena to give deposition testimony in the SEC lawsuits as fact witnesses. Ultimately, the SEC lawsuit was resolved by way of a settlement.


At the time of the SEC action, Gateway carried a total of $35 million in D&O insurance, arranged in three layers: a primary layer of $10 million; an excess layer of $10 million; and a second excess layer of $15 million. The primary and first excess layers were exhausted through payment of loss. The second excess layer advanced a total of about $12.18 million in payment of defense expenses, leaving about $2.82 million.


In connection with the testimony of the witness employees, attorneys’ fees of about $553, 875 were incurred. The second excess carrier denied coverage for this amount (referred to as the amount in dispute). Gateway sued the second level excess carrier to recover the amount in dispute. The parties filed cross motions for summary judgment on a stipulated record.


Relevant Policy Language and the Parties’ Respective Positions

The second excess policy incorporated the terms of the primary policy. Insuring Clause B of the primary policy provided that the insures shall pay loss “which the Company is required or permitted to pay as indemnification to any of the Directors and Officers resulting from any Claim firm made against the Directors and Officers during the Policy Period.”


Policy Section II.H.2 defined the term “Directors and Officers” to mean “to the extent any Claim is for …a Securities Law Violation, all persons who were, now are, or shall be employees of the Company.” Policy Endorsement No. 7 amended the definition of “Directors and Officers,” inter alia, by adding Policy Section II.H.5, to include within the definition “employees of the Company. However coverage for employees who are not directors or officers shall only apply when an employee is named as a co-defendant with a director or officer of the Company.”


Gateway argued Policy Sections II.H.2 and II.H.5 were independent clauses and that the attorneys’ fees incurred in connection with the employee witnesses were covered under Section II.H.2, because the SEC lawsuit was a Claim for “Securities Law Violation” against” Directors and Officers” (the three officer defendants in the SEC action), and the company incurred loss in connection with indemnifying the employees, who are “Directors and Offices” within policy section II.H.2. 


The second excess carrier argued first that as mere witnesses, the testifying employees were not parties to the civil action, and therefore no claim had been made against them. The second level excess carrier argued further that Endorsement No. 7 had modified the policy language to provide that “However, coverage for employees who are not directors shall only apply when an employee is named as a co-defendant with a director or officer of the Company.” The second level excess carrier argued that because none of the employee witnesses had been named as co-defendants, they were not “Directors and Officers” for whom reimbursement coverage was available under the policy.


The Court’s Decision

The fundamental question for the Court to decide was whether or not the “However” clause in Policy Section II.H.5 applied only to the preceding sentence in Policy Section II.H.5 or also applied to Policy Section II.H.2. (“However coverage for employees who are not directors or officers shall only apply when an employee is named as a co-defendant with a director or officer of the Company.”)


In his August 15, 2011 opinion in the case ruling in favor of Gateway, Southern District of California Judge William Q. Hayes found that the “clear and explicit reading” of the policy showed that Policy Sections II.H.2 and II.H.5 “are independent provisions” and the Gateway employees on whose behalf the disputed fees were incurred “constitute ‘Directors and Officers’ pursuant to sub-paragraph II.H.2.” The court said that “alternatively” the two “competing interpretations” of the definitional sections “highlight an ambiguity” in the policy language, which the Court construes in favor of Gateway.


Judge Hayes also rejected the second level excess carrier’s position that the employee witnesses attorneys’ fees did not come within Insuring Clause B of the policy because as mere witnesses no claim had been made against them. Gateway argued that Insuring Clause B required only that a claim have been made against Directors and Officers, which was the case in connection with the SEC action against the three Gateway officers, and in any event, the subpoenas directed to the employee witnesses constituted a claim against them as well. Judge Hayes said that the two parties “have advanced a reasonable interpretation of the Insuring Clause,” and accordingly the policy is ambiguous on this issue, and therefore the policy is interpreted in Gateway’s favor.


Judge Hayes granted summary judgment in favor of Gateway and against the second level excess carrier.



At one level, this decision is just a reflection of the interaction between the specific policy language and the circumstances presented. In the end, rather than choose between two alternative views, Judge Hayes found that the alternatives reflected an ambiguity and therefore ruled in favor of the insured on a more or less “tie goes to the runner” basis.


I am sure that at least some carrier-side observers may find it a surprising outcome that there was found to be coverage in connection with fees incurred for  non-party employee witnesses who were not defendants in the SEC action. In that regard, it is possible to look at the policy language as amended and to conclude that the Endorsement No7 had not been intended simply to add an alternative and independent provision bringing employees within the definition of covered “Directors and Officers,” but instead to fundamentally alter the policy’s coverage for employees.


Thus, in the base form, Policy Section II.H.2 afforded coverage for employees by bringing them within the definition of Directors and Officers, but only in connection with Claims for Securities Law Violations. The Endorsement amended the policy to remove the limitation restricting the coverage for employees only to Claims for Securities Law Violations, extending the policy’s coverage afforded to employees even for claims that did not involve Securities Law Violations, but specifying further that this broader employee coverage is only available when the employees are co-defendants with officers and directors of the company.


I think there is a good case to be made that that was what was intended at the time the changes were made. Unfortunately for the second level excess carrier, the amendments were accomplished through additional provisions rather than through delete and replace alterations. Because the Endorsement No. 7 amended by adding, the policy provisions necessarily had to be read together, thus creating the possibility that two different provisions could potentially apply to the same circumstance.


There is a practical lesson here for everyone who is involved in the process of modifying policy language through endorsement. That is, it is not enough that the language in the endorsement accomplishes what is intended to be accomplished. In addition, the endorsement language must also interact as intended with the language in the base policy form. Because I know how hard these issues are to manage, I am reluctant to postulate how these changes should have been done, as I may establish nothing but to show that in hindsight this language could have been structured differently. (My reluctance here is underscored by the fact that the second excess carrier that was forced to argue these issues here was forced to make these arguments based on language negotiated by the primary carrier, not by the excess carrier itself.) But all of that said, the disputes here could have been avoided if rather than simply adding an additional policy provision about coverage for employees, the endorsement had deleted and replaced the base form’s provision for employee coverage.


Because of his findings of ambiguity, Judge Hayes managed to sidestep a number of interesting issues, including, for example, whether or not the deposition subpoenas served on the employee witnesses constituted “Claims” within the meaning of the policy. As I have discussed in prior posts (most recently here), the question of whether or not a subpoena is a claim is one of the perennial D&O insurance coverage issues. It would have been particularly interesting for the Court to have explored in particular whether or not a deposition subpoena is or is not a claim under the applicable policy language. But Judge Hayes managed to make a decision without issuing rulings on many of the parties’ disputed issues, and so we will have to await another case and another day on many of these issues.


An Alternate List of Top Colleges: If for no other reason than its sheer perversity, the recently released Forbes Magazine list of theTop 100 U.S. colleges makes for some fascinating reading. What can you say about a list where West Point outranks Stanford, Harvard, MIT and Yale? (For that matter, Yale is not even in the top 10, coming in at number 14). Or where Haverford outranks Swarthmore, Claremont-McKenna outranks Pomona (that one was particularly unpopular in our house), Washington & Lee outranks Dartmouth, Colby and Bates are ranked ahead of Bowdoin, and Penn is ranked 52nd? And Michigan is ranked 93rd, just above Transyvania University? (The methodology used in compiling the Forbes list can be found here.)


One thing you can say is that the Forbes listmaker has a bias against public universities. The highest ranked public college on the list is UVa, coming in at 46th (another ranking particularly unpopular in our house).


If nothing else, the Forbes list is reminder not to get too hung up on the U.S. News and World Reports college list — it does not represent scripture, and there are many ways of looking at the many fine colleges in the U.S. As the excellent guidance counselor at my daughters’ school says, "College admission is a match to be made, not a prize to be won."