As I have noted in prior posts on this site (most recently here), the so-called “bump up” exclusion in D&O insurance policies is a frequent source of coverage litigation between D&O insurance policyholders and their insurers. The “bump up” exclusion precludes coverage for increased amounts participants in an M&A transaction agree to pay in the transaction in order to settle a M&A-related lawsuit. In the following guests post, Barry Buchman and Michael Scanlon take a look at the issues that can arise in disputes over the application of the “bump up” exclusion and consider the practical consequences. Barry is partner and Michael is counsel in the insurance recovery group at the Haynes and Boone law firm. I would like to thank Barry and Michael for allowing me to publish their article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is the authors’ article.
One of the principal purposes of public company directors and officers (“D&O”) liability insurance is to protect directors and officers from exposure to shareholder lawsuits stemming from merger and acquisition (“M&A”) activity. As one high-ranking executive of a major D&O insurer stated publicly, allegations of “wrongful acts” by board members of a target entity in such transactions fall within the “breadbasket” of D&O coverage.
This protection has become only more important over the past decade as M&A claims have increased in both frequency and severity. Historically, settlements of M&A claims typically involved only additional disclosures and plaintiffs’ counsel fees. More recently, however, multi-million-dollar settlements have become more common.
In response to this escalation in underlying M&A litigation, D&O insurers increasingly have invoked the so-called “bump-up” exclusion (“BUE”) to avoid covering M&A claims. According to insurers, the exclusion precludes coverage for settlements of M&A litigation that “bump up” the consideration that was paid to the shareholders of the target entity in the original M&A deal. But exactly when and how the BUE does so has been the subject of great debate and increasing amounts of novel litigation over the past five years.
This article explores the various issues and limited corresponding court decisions regarding the BUE that have arisen so far. It does so from a policyholder perspective, with explanations of why the BUE should not extend as far as D&O insurers assert. It concludes by providing some practical tips for policyholders, to help confine the potential impact of the BUE going forward.
II. Potential Limitations on the Bump-Up Exclusion
A. Buyer v. Seller
One of the first issues that was litigated in this context is whether the BUE bars coverage for M&A claims against a policyholder that is the target entity in the underlying transaction.
As noted above, at least some in the D&O insurance industry long understood that the BUE applies only to M&A claims against the buyer entity, and not vice versa. The reason for this distinction is simple: insurers have not wanted policyholders to negotiate what policyholders know is a lowball price when buying another entity and then use insurance proceeds to supplement the price when they get sued. By contrast, when a policyholder’s former shareholders allege that the policyholder’s directors and officers failed to obtain the best possible price for the company, such alleged negligence is precisely the type of “wrongful act” that D&O policies cover.
Some insurers have used policy language specifying that the exclusion applies only to claims arising from transactions in which the policyholder is the buyer. But even where a policy does not contain such express language, and even where it arguably indicates the opposite, extrinsic evidence regarding, among other things, D&O insurance industry custom and practice and/or the policyholder and insurers’ course of dealing can still lead to pro-coverage outcomes.
This was the result in Gardner Denver, Inc. v. Arch Insurance Company, Civil Action No. 16-0159, 2016 WL 7324646 (E.D. Pa. Dec. 16, 2016). There, the policyholder that paid the settlement was the target entity in the underlying transaction. The policy’s BUE barred coverage for the “amount representing, or substantially equivalent to, an increase in consideration paid or proposed to be paid in connection with any purchase of securities or assets of a Corporation.” Even though the policy defined “Corporation” to include the policyholder, the court denied the insurers’ motion to dismiss the complaint. The court cited to the policyholder’s detailed allegations regarding the above-referenced industry custom and practice and regarding the policyholder’s own prior dealings with its insurers. On the latter point, the policyholder alleged that the insurers previously had agreed that the BUE would apply only to claims arising from transactions where the policyholder was the buyer. The parties subsequently settled after significant discovery on those issues.
B. Acquisition or Purchase v. Merger
Another issue that has recently become a focus of litigation is whether certain versions of the BUE apply to business combinations accomplished through mergers (such as reverse triangular mergers) or whether such exclusions apply only to pure acquisitions or purchases, meaning takeover transactions where the original target entity survives.
A recent decision issued by the Delaware Superior Court awarded summary judgment to the policyholder on this issue, stressing that the underlying transaction was accomplished through a reverse triangular merger, rather than an acquisition. Specifically, in Northrup Grumman Innovation Systems, Inc. v. Zurich American Insurance Company, No. CV N18C-09-210, 2021 WL 347015, at *21 (Del. Super. Ct. Feb. 2, 2021), the court found that, under Delaware law, the AIG BUE is limited to acquisitions, which “in the corporate transactions context means a ‘takeover of one corporation by another if both parties retain their legal existence after the transaction.’” It therefore does not apply to a merger, which is a separate form of transaction and subject to its own distinct procedures.
Additional evidence lends support to the Northrop court’s analysis. Some policies treat mergers and acquisitions as separate forms of transactions when defining the term “Transaction.” There also are policies available in the marketplace that explicitly refer to both to a “merger” and an “acquisition” in their BUE. Therefore, BUEs that do not refer to “merger” or that do not refer to “any transaction” should not apply to business combinations accomplished through a merger.
We expect that there will be more litigation on this issue, which is still in its early stages. As in Gardner Denver, we expect that extrinsic evidence regarding D&O insurance industry custom and practice could become important to the evolution of this issue.
C. Disparate Consideration v. Inadequate Consideration
Another issue that has arisen is whether BUEs bar coverage where the underlying claim involves a dispute among shareholder classes. For example, the underlying M&A litigation at issue in Starz Acquisition, LLC v. Allied World Assurance Company (U.S.) Inc., Case No. 18stcv04283 (Cal. Super. Ct.), was brought by the holders of only one class of the target entity’s stock, who alleged that the transaction improperly favored the holders of another class of stock.
Such M&A claims are significant because many BUEs in the marketplace refer only to a “Claim alleging that the price or consideration paid or proposed to be paid for the acquisition or completion of the acquisition of all or substantially all the ownership interest in or assets of an entity is inadequate” (emphases added). The parties in the Starz case disputed what constitutes “all or substantially all the ownership interest in an entity.” The policyholders pressed the position that the BUE does not bar coverage when the underlying claim complains of disparate consideration among holders of different classes of the target entity’s stock, rather than claims by all of a target entity’s shareholders that the overall price paid for the whole company was too low. The parties engaged in discovery on the issue but then settled before any ruling on it.
D. Plaintiff Attorneys’ Fees
Insurers sometimes argue that the BUE reaches not only settlement payments made to shareholders themselves but also to plaintiffs’ counsel fees included in the settlement. BUEs available in the marketplace vary on this issue. For example, one recent policy form expressly defines the “Defense Expenses” that are exempted from its BUE to include “that portion of any settlement which represents the claimant’s attorneys’ fees.” Conversely, another BUE expressly specifies that there is no coverage for plaintiffs’ counsel fees. The majority of BUEs are silent on the issue.
Insurers should not be able to use a BUE’s silence on this issue to avoid coverage. Some jurisdictions find that an insurer’s failure to use available language expressly excluding coverage implies its intent to provide such coverage. Moreover, there is evidence regarding D&O insurance industry custom and practice that supports the view that plaintiffs’ counsel fees are covered unless explicitly excluded. As just one example, a slide deck provided by an insurer-side law firm states that an “award of plaintiffs’ attorneys’ fees is not excluded” and that “[e]ven multiplied portion of attorneys’ fees [are] covered because policy did not expressly preclude them.”
E. Defense Costs
Most, but not all, BUEs contain express carvebacks providing coverage for defense costs incurred by insureds to litigate underlying M&A claims. But, regardless of whether a BUE specifies this exemption, the custom and practice in the D&O insurance industry is that BUEs do not apply to defense costs.
F. Related Issues Regarding Coverage for Alleged Controlling Shareholders
Some M&A claims arise from transactions involving target entities that have purported controlling shareholders who allegedly violated their fiduciary duties to the company and their fellow shareholders. In such cases, policyholders may need to show that the policy provides “control person” coverage.
This issue could be relevant because, if the insurers believe that the allegedly controlling shareholder is not an insured, they likely will try to allocate liability to that shareholder to reduce their coverage obligations. Furthermore, if the settlement of the underlying case includes a release/indemnification of the alleged controlling shareholder that was not expressly approved by the insurers, the insurers may seek to void coverage based on a purported breach of the subrogation clause in the D&O policies. Thus, showing that the alleged controlling shareholder is an insured person is critical because many subrogation provisions preclude subrogation claims against an insured person.
This issue was hotly contested in the Starz case, in which a California Superior Court denied an insurer motion for summary judgment based on such a subrogation defense. The court ruled that the “unrefuted evidence” in the case established that the alleged controlling shareholder was an insured (despite not being a current director of the policyholder), and the subrogation clause in the policies precluded the insurers from subrogating against their insured.
III. Practical Pointers
There are steps that policyholders involved in M&A activity can take to maximize their chances of obtaining coverage under their D&O insurance policies if and when the need arises:
- Settlement Payments: Given the “buyer vs. seller” distinction discussed in Section II.A above, policyholders should pay attention to who pays any settlement to the underlying shareholders. Although it may not be necessary to obtain coverage later, it still may be preferable to have the target entity, on behalf of its directors and officers, pay the settlement or to commit to reimburse an affiliate that pays.
- Policy Language: Policyholders should examine the policy language both in the policy at issue and in their previous policies. They also should research whether there were policies in existence as of their most recent renewal with language that explicitly excludes the coverage that the insurers are seeking to avoid.
- Buyer v. Seller: Policyholders should determine whether their policies have, or ever had, language that would limit the scope of the BUE to claims arising from transactions in which the policyholder was the buyer. Even without such language in the policies at issue, such language in prior policies may enable the policyholder to establish that its insurers failed to bring the alleged narrowing of coverage to its attention during a renewal, as required under the law of some jurisdictions.
- Acquisition v. Merger; Inadequate Consideration v. Disparate Consideration: Policyholders should ascertain whether the BUE at issue specifically refers to “mergers” or “transactions” in addition to “acquisitions” or “purchases” and whether it is tied to transactions involving “all or substantially all assets or securities” versus “any assets or securities.”
- Plaintiffs’ Counsel Fees: Policyholders should determine whether their BUE specifically bars coverage for plaintiffs’ counsel fees. If not, they should take discovery regarding insurance industry custom and practice regarding covering such fees, including seeking information about whether and why their insurers have ever paid plaintiffs’ counsel fees in connection with an M&A claim.
- Control Person Coverage: Policyholders should investigate whether their policy contains an endorsement providing coverage for alleged controlling shareholders. Such coverage sometimes is afforded through so-called “control person” endorsements. These endorsements vary. Some may expressly limit coverage to large shareholders who also are current directors and officers. Others cover specifically-named persons. Still others reach both current and former directors and officers or do not even require that the “control person” be or have been a director or officer. Where the endorsement does not establish coverage on its face, policyholders should gather extrinsic evidence regarding the negotiation of that provision to show whom it was meant to protect.
- Choice-of-Law and Related Forum: As illustrated by the different outcomes in Gardner Denver and Joy Global (see note 4), different jurisdictions take different approaches regarding whether extrinsic evidence may establish a latent ambiguity and whether and to what extent courts consider the reasonable expectations of the insured. Therefore, a policyholder must carefully consider both what law might apply to its coverage case and where to bring its case to maximize the chances that favorable law will apply. Although policyholders need not rush to file a complaint, they should have a pleading prepared to file in case an insurer files a preemptive declaratory judgment action in a jurisdiction with law that is unfavorable to the policyholder.
The coverage provided by D&O insurance policies for M&A claims (and for other claims) can be an extremely valuable business asset. Insureds can maximize the value of that asset by acting proactively to analyze it and refusing to accept coverage denials from their insurers at face-value.
Barry Buchman is partner and Michael Scanlon is counsel in the insurance recovery group of Haynes and Boone, LLP. The opinions expressed in this article are solely those of the authors and not those of Haynes and Boone, LLP, any of its clients, or any of the other members of the firm. This article also does not constitute or provide legal advice.
 Gloria Gonzalez, Merger objection lawsuits driving D&O rates up, Business Insurance, Oct. 9, 2018, https://www.businessinsurance.com/article/20181009/NEWS06/912324459/Merger-objection-lawsuits-driving-directors-and-officers-rates-up.
 The authors represented Gardner Denver in this case.
 Two courts since have issued decisions finding no coverage where the policyholder was the target entity, but neither disturbs the reasoning in Gardner Denver. In Onyx Pharmaceuticals Inc. v. Old Republic Insurance Company, No. CIV 538248, 2020 WL 9889619 (Cal. Super. Ct. Oct. 1, 2020), a California Superior Court originally found that the language of the BUE was ambiguous and then held a bench trial to resolve that ambiguity. Thus, the Onyx court agreed with the Gardner Denver court that, at minimum, the BUE does not clearly bar coverage when the policyholder is the target entity. The subsequent pro-insurer, post-trial decision, which still has not been entered as a judgment, was based on fact-specific evidence unique to that case. In Joy Global Inc. v. Columbia Casualty Company, No. 2:18-CV-02034, 2021 WL 3667077, at *4 (E.D. Wis. Aug. 18, 2021), the court rejected arguments by the policyholder regarding the history and purpose of the BUE because, in its view, Wisconsin law does not allow parties to introduce extrinsic evidence regarding insurance industry custom and practice or the parties’ course of dealing when policy language is unambiguous.
 The policyholder in a recent BUE case noted that “Gardner Denver is the leading case in the country that interprets bump-up exclusions.” Mem of L. in Supp. of Pl.’s Mot. for Partial Summ. J. at 20 n.8, Towers Watson & Co. v. National Union Fire Ins. Co. of Pittsburgh, PA, 2020 WL 9893163 (E.D.Va. Aug. 6, 2020), ECF No. 20.
 See also Towers Watson & Co. v. National Union Fire Ins. Co. of Pittsburgh, PA, No. 120CV810AJTJFA, 2021 WL 4555188, at *9 (E.D. Va. Oct. 5, 2021) (same).
 Towers Watson & Co., 2021 WL 4555188, at *10.
 The authors were counsel for Starz (and Lionsgate).
 Fundamentals of, and Insurance Coverage for, Merger Objection Suits, https://media.lockelord.com/files/Uploads/Documents/Fundamentals%20of%20and%20Insurance%20Coverage%20for%20Merger%20Objection%20Suits%20-%20The%20Basics%20PRESENTATION%207-17-13.pdf.
 Starz Acquisition, LLC v. Allied World Assurance Co. (U.S.) Inc., Case No. 18STCV04283, Slip Op. at 9–12 (July 30, 2020).
 Id. at Slip Op. 11–12.
 The Northrop case is of particular significance to policyholders because the Delaware Supreme Court has found that Delaware law typically applies in cases involving director and officer honesty and fidelity to the corporation. RSUI Indem. Co. v. Murdock, 248 A.3d 887, 900 (Del. 2021). Thus, the many companies that are incorporated in Delaware can benefit from that decision.