One of the thorniest D&O insurance coverage issues is the question of the applicability of a policy exclusion when coverage preclusive conduct has been alleged – but not proven. In a November 14, 2011 opinion (here), District of Oregon Judge Ann Aiken held that the mere allegations in the underlying claim, even if otherwise sufficient to constitute precluded “bad faith” within the meaning of a policy exclusion, were insufficient to preclude coverage where the underlying claim settled and the allegations were not proven. Though the specific exclusion involved is unusual, the dispute itself raises a number of interesting issues.

Background

Summit Accomodators, Inc. was in the business of facilitating so-called “1031 exchanges.” The company experienced liquidity issues in late 2008 and filed for bankruptcy. In June 2009, the trustee for the Summit Accomodators Liquidation Trust filed a civil action against Umpqua Bank, alleging that the bank knowingly aided and abetted the principals of Summit in the perpetration of a multi-million dollar Ponzi scheme.

Among other things, the trustee’s complaint alleged that “highest level of management at Umpqua Bank … became fully aware of the Ponzi scheme and the principals’ embezzlement. …Yet [the bank officials] continued to actively encourage and materially assist the Summit principals.” The bank is alleged to have aided the scheme by providing banking services including loans and by encouraging bank customers to use Summit’s services.  Additional lawsuits later arose. The suits were later consolidated and ultimately settled.

At the time the claims arose, the bank was insured under a D&O liability insurance policy. The insurer funded the bank’s defense in the litigation. However, the insurer disputed that the policy provided coverage for the underlying settlement. Ultimately, the insurer contributed 41% of the settlement amount. The bank sued the insurer for breach of contract (refer here for the bank’s complaint), seeking to recover the balance of the settlement amount from the insurer. The insurer answered the complaint and also counterclaimed for return of the 41% of the settlement that it had funded, arguing that there was no coverage under the policy for the settlement (refer here for the insurer’s Answer and Counterclaim).

In arguing that the policy precluded coverage for the settlement, the insurer relied on Policy Section V (illegal profit/payment exclusion):

The Insurer shall not be liable to make any payment for Loss, other than Defense Costs, in connection with any Claim arising out of or in any way involving:

1. any Insured gaining, in fact, any profit, remuneration, or financial advantage to which the Insured was not legally entitled;

2. payment by the Company of inadequate or excessive consideration in connection with the purchase of Company securities; or

3. conflicts of interest, engaging in self-dealing, or acting in bad faith. 

In disputing coverage, the insurer relied principally on subsection 3 of this provision, the “bad faith” exclusion.

The insurer moved for judgment on the pleadings, arguing that the applicability of the bad faith exclusion could be determined “based solely on the undisputed terms of the complaints in the underlying litigation against the bank.” (The insurer’s memorandum in support of its motion for judgment on the pleadings can be found here). The bank filed a cross-motion for summary judgment.

The November 14 Order

In her November 14, order, Judge Aiken denied the insurer’s motion for judgment on the pleadings and granted in part the bank’s cross-motion for summary judgment. In making her ruling, Judge Aiken did not construe the phrase “acting in bad fait,” or determine whether the underlying allegations constituted “bad faith,” as she deemed it sufficient to determine whether or not the exclusion could be triggered by the mere allegations in the underlying litigation.

The insurer had argued that the egregious allegations of the bank’s complicity in the alleged Ponzi scheme were sufficient to trigger the exclusion. In support of its contention that allegations alone were sufficient, the insurer argued that the reference in the policy’s definition of Wrongful Act to an “actual or alleged” act, error or omission was incorporated into all of the policy exclusions, setting up an “allegations alone” trigger for all exclusions. The insurer also contrasted subpart 1 of the exclusion at issue, which expressly required an “in fact” determination that that the precluded conduct occurred, with the “bad faith” subpart, which has no such “in fact” determination requirement.

Judge Aiken rejected these arguments.  First, she found that, contrary to the insurer’s “surreptitious interpretation,” the exclusion “does not actually state that it is triggered by allegations of bad faith,” and that “the word ‘alleged’ is at no point used within the exclusion.” She added that “in its attempt to avoid its contractual duty to indemnify,” the insurer “erroneously substitutes the term ‘alleged act’” in its interpretation of the exclusion.

Judge Aiken noted further that when the insurer “intended the policy exclusions to be activated by mere allegations, it did so expressly within the actual text of the policy.” She noted in that regard that both the policy’s Pollution Exclusion and its Bodily/Personal Injury and Property Damage Exclusion both expressly reference “alleged” activity or conduct as triggering the exclusion.

Finally, she noted that “at the very least,” the insurer’s “imprecise drafting allows the Exclusion to have more than one reasonable interpretation,” and accordingly she was required to construe the policy in favor of coverage.

Discussion

A recurring problem D&O insurers face is the question of their coverage obligations in circumstances  involving alleged egregious misconduct, when the misconduct has not yet been the subject of formal proof. Two scandals currently on the front pages of the business sections illustrate this issue. The newspapers are full of stories suggesting that MF Global improperly applied customer funds. Olympus Corp. has actually admitted that it misrepresented certain transaction costs in order to mask certain investment losses.

The general movement in most D&O insurance policies in recent years has been toward an “after adjudication” standard for conduct exclusions, meaning that the exclusionary language does not preclude coverage unless and until there has been a judicial determination that the precluded conduct has occurred. To the extent that the conduct exclusions in the MF Global or Olympus insurance policies apply only after an “adjudication,” the exclusions in those policies would not presently operate to preclude coverage notwithstanding the allegations or admissions involving the companies. Indeed, because so few directors and officers liability cases actually go to trial, there are rarely “adjudications” and so the preclusive effect of the conduct exclusions is rarely triggered.

I refer to these contemporary examples to highlight the fact that, at least as most current D&O insurance policies are written, D&O insurers are often called upon to provide coverage even in the circumstances involving egregious underlying allegations. Clearly, in the Umpqua Bank case, the insurer was deeply troubled by the allegations in the underlying complaint of the bank’s complicity in the alleged Ponzi scheme. But as disturbing as the trustee’s allegations may be, the mere fact that these things were alleged does not mean that any of these things actually happened or that they happened the way the trustee alleged.

The exclusion at issue in the Umpqua Bank case contained no “adjudication” requirement. It did not even, as the insurer pointed out, contain an “in fact” provision requiring that the precluded conduct occurred.  The absence of these types of provisions allowed the interpretation of the exclusionary language that the carrier took in this case, and makes the carrier’s position not unreasonable.

However, the exclusions’ lack of a specific trigger does not necessarily mean that mere allegations alone are sufficient to trigger the exclusion.Many (if not most) directors and officers liability complaints contain allegations asserting  “conflicts of interest, engaging in self-dealing, or acting in bad faith.” If those types of mere allegations alone were sufficient to preclude policy coverage, then the exclusion’s preclusive effect would reach so broadly that it would swallow up much of the intended coverage for which the policyholder purchased the policy in the first place. Certainly, it would seem that if the insurer was to narrow coverage so dramatically for mere allegations, then it ought to do so explicitly.

Indeed the potentially preclusive scope of this policy exclusion may explain why the exclusion is relatively unusual. Many purchasers and their advisors would find it better to avoid policies with this type of language, particularly given this insurer’s formulation of the language.

By the same token, the potential breadth of the exclusion’s preclusive effect is yet another reason to support Judge Aiken’s narrow interpretation. If the parties had intended mere allegations of  “conflicts of interest, engaging in self-dealing, or acting in bad faith” to preclude indemnity coverage, then the exclusion would have expressly included the word “alleged,” as was the case with the two other policy exclusions Judge Aiken referenced in her opinion. The presence of the word “alleged” in the other exclusions and its absence in the “bad faith” exclusion, at a minimum, allows, as Judge Aiken found, “more than one reasonable interpretation” of the question whether or not mere allegations are sufficient to trigger the “bad faith” exclusion.

Readers who are wondering why the name Umpqua Bank sounds familiar may recall that in an earlier post (here), I wrote about the derivative lawsuit that the shareholders of Umpqua’s holding company filed against company officials after t  62% of shareholders voted “no” in the advisory shareholder vote on the company’s 2010 executive compensation plan. The claims asserted in the lawsuit rely directly on the negative note.

FDIC Files Another Failed Bank Lawsuit: And speaking of bank litigation — the FDIC has filed another lawsuit against the former directors and officers of a failed bank. On November 18, 2011, the FDIC filed an action in the Western District of Washington against eleven former directors and officers of Westsound Bank, which failed on May 8, 2009. A copy of the complaint can be found here.

In its complaint, the FDIC seeks to recover at least $15 million in principal losses the bank suffered on 28 commercial loans. The complaint alleges that the defendants failed to properly supervise the bank’s lending operations. The complaint alleges that certain loans were approved in violation of the bank’s lending policies and in disregard of regulatory warnings.

The complaint further alleges that 21 fraudulent loans to the Russian/Ukrainian community would not have been made if the defendants had heeded regulatory warnings and properly supervised lending operations. Finally, the complaint seeks to recover losses on preferential loans that were made to directors and director-led companies.

The FDIC’s complaint against the former Westsound Bank officials is the 17^th the agency has filed against former directors and officers of failed banks as part of the current wave of bank failures. Like many of the suits the FDIC previously filed, this one came well over two years after the bank’s failure. The sheer number and timing of the bank failures during the current wave (which now total over 400) and the FDIC’s deliberate litigation approach suggests that there are many other lawsuits to come in the months and years ahead.

The FDIC recently updated its professional liability lawsuits page on its website to reflect that the agency has approved an increased number of lawsuits. The updated page (here) shows that as of November 14, 2011, the FDIC has authorized suits in connection with 37 failed institutions against 340 individuals for D&O liability with damage claims of at least $7.6 billion. Though the FDIC has authorized lawsuits involving 37 institutions, it has filed only 17 lawsuits involving 16 institutions so far – suggesting that there are many lawsuits yet to come, just taking into account the lawsuits authorized so far.

With more lawsuits likely to be authorized in the future, and with banks continuing to fail (two more were closed this past Friday evening), it seem probable that the number of lawsuits involving former directors and officers of failed banks will continue to accumulate for years to come.

Cybersecurity Disclosure: In the quarterly Advisen webinar last week, one of the topics discussed was the SEC’s new disclosure guidelines regarding cybersecurty risks and exposures. Readers interested in learning more about the SEC’s guidelines will want to refer to the November 17, 2011 memorandum from John Nicholson of the Pillsbury law firm, entitled “Accounting for Cybersecurity: SEC Guidance in Disclosures to Investors and Regulators” (here). The memo includes a detailed discussion of the new guidelines and the challenges that companies may face in trying to comply with the guidelines.