D&O Insurance: Bankruptcy Trustee’s Fraudulent Transfer Claim is a “Securities Claim”

By Kevin LaCroix on February 28, 2021

As I noted in a recent post (here), a recurring public company D&O insurance coverage issue is whether a claim in which a company is involved qualifies as a “Securities Claim.” This question matters because D&O insurance provides coverage for the corporate entity (as opposed to the insured directors and officers) only for “Securities Claims” as that term is defined in the policy. In a recent decision, a Delaware Superior Court judge concluded that a bankruptcy trustee’s fraudulent transfer claim against Verizon Communications and related entities came within the applicable D&O insurance policy definition of “Securities Claim.” The coverage dispute illustrates the intricate issues that can arise in determining whether a claim qualifies as a “Securities Claim.” A copy of the Court’s February 23, 2021 Opinion can be found here.

Background

In March 2008, through a complex three-party transaction, Verizon spun-off certain telecommunications assets (landlines) to FairPoint. To accomplish the spin-off, Verizon sold the assets to Spinco, a wholly owned subsidiary of Verizon. Spinco issued corporate debt notes to Verizon. Verizon then divested Spinco by spinning out its stock to Verizon’s stockholders. Spinco and FairPoint merged, with FairPoint as the surviving entity. Spinco’s stock was cancelled and converted to “new” FairPoint stock. As a result of the transaction, FairPoint acquired ownership of the telecommunications assets, as well as the debt obligation to Verizon on the corporate debt notes Spinco has issued to Verizon. Verizon sold the notes to investment banks which in turn sold the notes to third-party buyers.

Following the completion of the transaction, FairPoint was unable to service its outstanding operating debt and the Spinco notes. In October 2009, FairPoint filed for Chapter 11 bankruptcy. The ensuing plan of reorganization created a trust with an appointed Trustee authorized to pursue litigation, including Spinco-related causes of action. In October 2011, the Trustee filed an action (the “FairPoint action”) against Verizon in which the Trustee sought to avoid alleged actual and constructive fraudulent transfers connected to the landline assets spinoff transaction. Among other things, the Trustee alleged that FairPoint was insolvent at the time of the spinoff transaction. Verizon and related entitles ultimately settled the FairPoint action for $95 million. Verizon and related entities incurred approximately $24 million in attorneys’ fees defending the FairPoint action.

The Insurance Policies

There were two D&O insurance programs relevant to this dispute. The first was a program of insurance, consisting of a primary policy and three layers of excess insurance, that was issued to Verizon for the policy period October 31, 2009 to October 31, 2010. The second was a program of insurance, consisting of a primary policy and two layers of excess insurance, issued to FairPoint for the policy period March 31, 2008 to March 31, 2014. The primary policy in both programs was issued by the same insurer and the policy terms and conditions of the two primary policies was substantially the same. Significantly, the insured Organization in the FairPoint policy was defined to include both FairPoint and Verizon.

Verizon sought insurance under the policies for the FairPoint action settlement and defense costs. When the insurer declined to pay these amounts, Verizon filed a breach of contract action against the insurers. Verizon filed a motion for partial summary judgment with respect to the defense costs. The insurers filed a motion for judgment on the pleadings, arguing, among other things, that the Trustee’s fraudulent transfer claim was not a “Securities Claim,” and therefore there is no coverage for the underlying claim.

The Relevant Policy Language

The policies define a “Securities Claim” as a claim made against any Insured:

(1) alleging a violation of any federal, state, local or foreign regulation, rule or statute regulating securities (including but not limited to the purchase or sale or offer or solicitation of an offer to purchase or sell securities) which is: (a) brought by any person or entity alleging, arising out of, based upon or attributable to the purchase or sale or offer or solicitation of an offer to purchase or sell any securities of an Organization; or (b) brought by a security holder of an Organization with respect to such security holder’s interest in securities of such Organization; or

(2) brought derivatively on the behalf of an Organization by a security holder of such Organization.

Verizon argued that the Trustee’s fraudulent transfer claim came within paragraph (2) of the definition, contending that the Trustee was a “security holder” within the meaning of the Bankruptcy Code and that the fraudulent transfer action was brought “derivatively.” The insurers disputed these arguments.

The February 23, 2021 Opinion

In his February 23, 2021 opinion, Delaware Superior Court Judge Eric Davis granted the insureds’ partial summary judgment on the defense cost issue and denied the insurers’ motion for judgment on the pleadings on the “Securities Claim” issue.

Judge Davis began his analysis of the “Securities Claim” issue by referring to the Delaware Supreme Court’s 2019 opinion in an earlier coverage dispute also involving Verizon and also involving the question whether or not an underlying bankruptcy trustee’s claims which included, among other things, a claim for fraudulent transfer, came within the policy’s definition of “Securities Claim.” The Delaware Supreme Court concluded in that case that the underlying claim did not meet the definition. However, as Judge Davis noted, definition of “Securities Claim” at issue in the earlier case was “critically different” from the definition at issue with respect to the FairPoint action. The definition at issue in the earlier case provided as follows:

(2) brought derivatively on the behalf of an Organization by a security holder of such Organization, relating to a Securities Claim as defined in paragraph (1) above.

As Judge Davis noted, the policy language at issue in the FairPoint action dispute did not contain the italicized phrase shown above in the paragraph (2), and therefore in this case, Verizon, relying on the derivative action provision in the “Securities Claim” definition, did not have to show “a regulating-securities element” in order to establish coverage.

Judge Davis then concluded that under the “plain language” of the FairPoint policy, the FairPoint action is a “Securities Claim.” In reaching this conclusion, he first concluded that the Spinco notes were “securities.” He then concluded that the Bankruptcy Trustee is a “security holder” within the meaning of the definition, in reliance upon and with reference to the Bankruptcy Code. In that regard, he noted that the Trustee alone could prosecute claims belonging to the bankrupt estate, and reasoned that the Trustee brought the FairPoint action as a “security holder” because, by operation of law, no security holder could assert the claim. Judge Davis rejected the insurers argument that the Trustee did not actually hold the securities; he noted that “the Insurer’s reading would, in fact, relieve them of their obligation to cover Securities Claims if FairPoint goes bankrupt.”

Judge Davis also concluded that the FairPoint action was “brought derivatively” because the claim was brought on behalf of the estate for the benefit of all of the creditors, and therefore was a derivative claim, not a direct claim, and so the “brought derivatively” element of the definition of “Securities Claim” was established. Judge Davis rejected the insurers argument that the “brought derivatively” phrase was meant to refer only to a paradigmatic stockholder breach of fiduciary duty claim, holding that the policy language “does not support such a constraint.” Judge Davis also concluded, because the claim was brought for the debtor’s estate, that the FairPoint action was “brought on behalf of” FairPoint.

Finally, Judge Davis held that Verizon was entitled to coverage for its defense costs under the FairPoint policy. In effect, he held that the insurers had waived the right to object to the reasonableness or necessity of the fees incurred. He said, “after denying coverage and basically ignoring the FairPoint Action for six years, the Insurers now complain that the Insureds’ fees are unreasonable and unnecessary.” Among other things, he said that “the Court is not equipped to second-guess the ‘reasonableness’ fees the Insurers now untimely bemoan.” He rejected the insurers’ argument that the preserved their right to object to the fees because they had “reserved all their rights” in their coverage letters. He held that the insurers had failed to raise a genuine issue of material fact with regard to the defense cost issue and granted the insureds’ motion for summary judgment on the issue.

Discussion

It is an interesting coincidence that this ruling on the definition of “Securities Claim” from the Delaware Superior Court comes just days after a ruling by the United States District Court for the District of Delaware in the Calamos case (discussed here) on definition of “Securities Claim.” The two courts reached opposite results; in this case, the Superior Court concluded that the underlying claim was a “Securities Claim,” while the District Court in the Calamos case concluded that the underlying claim (a breach of fiduciary duty action) was not a “Securities Claim.”

Obviously, the most important reasons for the differences in outcomes between the two cases have to do with important differences both in the policy language involved and in nature of the underlying claims. However, there are some other things worth pointing out with respect to the differences in outcomes.

First, just as a general matter, it comes as no surprise that the policyholder-friendly result between these two decisions is the one that came out of the Delaware Superior Court. As I have noted frequently on this site (most recently here), the Delaware Superior Court has unquestionably proven to be a policyholder-friendly forum. Indeed, as I was reviewing the Delaware District Court’s recent decision in the Calamos case a few days ago, I couldn’t help but thinking that the outcome in that case might well have been different if it had been before the Delaware Superior Court rather than the Delaware District Court. (A well-known and highly regarded insurer-side coverage attorney said as much to me at the time.)

Second, I think it is both noteworthy and important that Judge Davis in this case, by contrast to Judge Noreika in the Calamos case, considered that there were important and determinative differences between the language of the “Securities Claim” definition involved in the earlier Verizon dispute before the Delaware Supreme Court and the language of the “Securities Claim” definition involved in this case. By contrast, Judge Noreika noted a difference in wording in the Calamos coverage dispute, but (wrongly in my view), proceeded to analyze the coverage issues as if the “Securities Claim” definition in the Calamos dispute were analytically no different than the one involved in the earlier Verizon dispute before the Supreme Court. This important difference in analytic approach is an important consideration in explaining the differences in outcomes between this case and the Calamos case.

It is more than just an interesting coincidence that this case and the earlier Delaware Supreme Court both involved Verizon. The connection is not just that both involved the same company (and indeed, the same primary insurer) but also that both this case and the earlier dispute that wound up before the Delaware Supreme Court both involved complicated underlying transactions in which Verizon spun-out various money losing assets to third-party vehicles that, with the “benefit” of the spun-out assets, promptly went bankrupt. The track record for these Verizon spin-out deals is not, shall we say, impressive.

As is often the case when trying to figure out from the outside what is going on in a particular insurance coverage dispute, there are some mysteries about this situation. For starters, why was Verizon a named insured on the FairPoint policy? The spin-out transaction was complicated, but essentially Verizon was selling FairPoint some telecommunications assets in exchange for debt. I am sure the parties involved could explain it, but I can’t see why Verizon was named as an insured under the D&O insurance policy of a third-party asset purchaser. Also, in passing, Judge Davis notes that the Verizon entities “have not sought Securities Claim coverage under the Verizon Policy for the FairPoint action.” I am sure there is a reason why Verizon was seeking Securities Claim coverage under the FairPoint policy rather than under its own D&O policy, but I can’t figure out why from the bare face of Judge Davis’s opinion.

All of that said, this case and the earlier cases do demonstrate the coverage tension that is created under a public company D&O insurance policy by the fact that entity coverage is limited to Securities Claims. This long-standing and well-established limitation puts policyholders into the position where they have to try to characterize the disputes in which they are involved as “Securities Claims” in order to try to secure coverage. Judge Davis’s opinion in this case shows how intricate disputes of this issues can become. I suspect that the insurers in this case, the news that the underlying claim involving a bankruptcy trustee’s fraudulent transfer claim is a “Securities Claim” represents a surprise outcome, particularly after the Delaware Supreme Court said in the earlier Verizon case that a bankruptcy trustee’s fraudulent transfer action was not a “Securities Claim” (albeit under a policy definition with an important difference in wording). All I can say about that is – refer to the paragraph above about the Delaware Superior Court.

And if the insurers were surprised by the court’s conclusion on the “Securities Claim” issue, they really were not expecting Judge Davis’s testy ruling on the defense cost issue. The insurers surely felt they had no prior obligation to analyze attorneys fees that they believed were not covered in the first place, but Judge Davis seems to be saying to the insurers you still should have gone ahead and analyzed the fees, and further that the failure to do so in effect waives the right to question the fees later. This conclusion undoubtedly will put some unwanted and welcome pressure on D&O insurers claims operations, as it suggests that the insurers must contemporaneously analyze attorneys’ fees they believe are not covered in order to preserve the right to dispute fees later.

I wouldn’t be surprised at all to learn that there are discussions going on at this very moment in the corridors (or perhaps the virtual corridors) of the leading D&O insurers about the need to add forum designation provisions to their D&O insurance policies, in order to specify a forum other than the Delaware Superior Court.

Special thanks to a loyal reader for sending me a copy of this opinion.