A federal district court, applying California law, has held that the insurers must advance “potentially covered” subpoena-related expenses to the post-merger entity and that the Change in Control Exclusion did not preclude advancement. The coverage decision raises some interesting issues. And, as discussed below, it raises also raises concerns about the policy language, as well. A copy of the Northern District of California’s February 12, 2024, decision can be found here. A February 26, 2024 post on the Wiley law firm’s Executive Summary blog can be found here.

Background

KBL Merger Corp. IV was a Special Purpose Acquisition Company (SPAC). Marlene Krauss was KBL’s CEO. George Hornig was a director of KBL. KBL merged with a private company on November 6, 2020, to form 180 Life Sciences Corp. Krauss and Hornig resigned from their positions at the time of the merger.

After the merger, the SEC issued subpoenas to Krauss and Hornig. Krauss and Hornig sought and obtained a prior court order requiring 180 Life Sciences to advance the expenses they incurred in responding to the subpoenas.

KBL had purchased a program of D&O insurance consisting of $3 million of primary insurance and $2 million of excess insurance. 180 Life demanded coverage for the subpoena response expenses for which it was reimbursing Krauss and Hornig. The primary insurer disputed that 180 Life was an insured under its policy and contended that in any event the expenses were subject to policy exclusions. Coverage litigation ensued. In a prior ruling, the court in the coverage lawsuit held that 180 Life is an insured under the primary policy and that the subpoenas are claims under the policies.

Life 180 then sought a partial summary judgment that the primary policy’s Advancement Clause required the insurers to advance the subpoena-related defense costs subject to reimbursement in the event of a determination that there is no coverage for the costs. The insurers disputed that advancement was required and argued that in any event coverage for the costs was precluded by the policy’s Change of Control Exclusion.

The Relevant Policy Language

The primary policy’s Advancement provision provides in relevant part that:

The Insurer shall advance Defense Costs in excess of the applicable Retention on behalf of the Insured not less often than every 90 days and prior to the final disposition of the Claim. Such advanced payments by the Insurer shall be repaid to the Insurer by each and every Insured, severally according to their respective interests, in the event and to the extent that any such Insured shall not be entitled under the Terms and Conditions of this Coverage Element to pay such Loss.

The Change in Control Exclusion provides:

If during the Policy Period: 1. the Named Insured shall consolidate with or merge into any other entity or group of persons or entities acting in concert, or 2. any person or entity or group of persons or entities acting in concert shall acquire Management Control of the Named Insured,

(1 and/or 2 herein referred to as a Change in Control), then this policy may not be cancelled thereafter and it shall not, in any event, apply to any Claim alleging in whole or in part and Wrongful Acts committed, attempted or allegedly committed or attempted by any Insured subsequent [to] the date of such Change in Control.

The February 12, 2024, Order

In a February 12, 2024, Order, Northern District of California Judge Beth Labson Freeman, applying California law, granted the insurer’s partial summary judgment motion, holding that Life Science 180 was entitled to advancement of the subpoena-related defense expenses and that the insurers has not established that the Change in Control Exclusion precluded coverage because they had not shown that the subpoena related to post-merger Wrongful Acts.

Life Sciences 180 had argued that the primary policy’s Advancement provision was triggered when there are “potentially covered” Claims. The insurers argued that advancement is triggered only by “actually covered Claims.” The court found that the policies required to insurers to advance defense costs for potentially covered claims as they are incurred.

In making this ruling, Judge Freemen distinguished the language used in the policy at issue in this case, which provided for advancement with a right of recoupment if it turns out the expenses are not covered, from what she called “typical D&O policies” that “require payment of defense costs only after they have been shown to be a component of indemnified loss.” Judge Freemen quoted with approval from a prior decision in the same judicial district as saying, in connection with a D&O insurance policy with similar language, that “this right of repayment after a final determination of coverage only makes sense if the duty to advance defense costs is triggered by potential coverage.”

The court then turned to the question whether the Change in Control exclusion precluded coverage. Under this exclusion, coverage for the subpoenas is barred if they “allege in whole or in part any Wrongful Acts committed, attempted or allegedly committed or attempted by” Krauss or Hornig during the post-merger period. In support of their argument, the insurers pointed to the fact that the subpoena sought production of documents from both prior to and subsequent to the merger.

Judge Freeman acknowledge that the question of the potential application of the exclusion is a “close question.” She said that it certainly is possible that SEC is investigating Krauss and Hornig for alleged wrongful acts in the post-merger time period, as the dates of the requested documents could be read to suggest. However, she said, “the possibility that the SEC may be investigating Krauss and Hornig for post-merger misconduct does not conclusively establish that the Change in Control Exclusion applies.”

Simply put, Judge Freeman said, “the Insurers have not presented any evidence that Krauss and/or Hornig are suspected of, or being investigated for, post-Merger misconduct.” The Insurers speculation that the SEC may be investigating is insufficient. The Insurers, she noted, may be able to make the showing later, and if so, “they will be able to recoup any Defense Costs advanced.” However, on the “limited record before it, the Court finds that there is potential coverage for the SEC subpoena.”

Discussion

The court’s holding that “potential coverage” is sufficient to trigger the policy’s advancement requirement, and rejecting the insurers’ argument that only “actually covered” trigger the advancement requirement, is very much a reflection of the policy language. She said the Advancement provision in the policy “clearly contemplates advancement of Defense Costs for potentially covered Claims, subject to recoupment by the Insurer if it ultimately turns out that the Claims are not covered.”

The importance of the policy language involved is worth stressing. Judge Freeman distinguished the policy language at issue in this case from what she called “typical D&O insurance policies,” which, she said, “require payment of defense costs only after they have been shown to be a component of indemnified loss.”

Judge Freeman also distinguished this situation from cases on which the insurers sought to rely in which the policies at issue in those cases did not have advancement clauses and or involved policies that contained language expressly limiting advancement to costs for which the policies provide coverage.

Thus, while policyholder-side advocates will take comfort from Judge Freeman’s conclusion that only a showing of potential coverage is required to trigger the advancement requirement, her conclusion in that regard is very much a reflection of the specific language involved.

Having determined that potential covered claims were sufficient to trigger the policy’s advancement requirement, Judge Freeman then turned to the question of whether or not the claims were even potentially covered.

The insurers argued that the claims were not even potentially covered because they related to acts that took place after the merger. The insurers argument in this regard was based on the fact that the subpoenas sought production of documents from both before and after the merger. Judge Freeman said that the mere fact that post-merger documents were sought was not enough to establish at this point that the SEC’s investigation involved both pre- and post-merger wrongful acts.

I can anticipate that some insurer-side coverage attorneys may be troubled by Judge Freeman’s determination of the Exchange of Control Exclusion. Insurer-side advocates may well be persuaded that the fact that the subpoenas sought production of both pre- and post-merger documents should be sufficient to establish that the subpoenas related “in whole or in part” to post-merger acts, and therefor that the Change in Control Exclusion precluded coverage.

Judge Freeman herself acknowledged that the issues is a “close question,” and based her decision on the fact that it was the insurers’ obligation to present evidence “conclusively” showing that the exclusion applies. She concluded that the insurers had not carried that burden. The insurers’ consolation, such as it is, is that she allowed that the insurers may be able to make the showing later, in which case they will be able to recoup the advanced defense costs.

For myself, I have to say I am troubled by the Change in Control Exclusion itself. Why on earth should this exclusion be written so that the allegation of any post-merger wrongful acts precludes coverage entirely, for all wrongful acts, even pre-merger wrongful acts? While it certainly is justifiable that coverage is precluded for loss arising from claims for post-merger wrongful acts, on what possible basis does it make sense that coverage even just for loss arising from claims for pre-merger wrongful acts is barred merely because there are also post-merger wrongful acts alleged?

Consider the following thought problem. Imagine a situation in which 99 pre-merger wrongful acts are alleged. Subject to all policy terms and conditions, all 99 pre-merger wrongful acts would be covered. Now consider a slightly different scenario in which 99 pre-merger wrongful acts are alleged AND a single post-merger wrongful act. Under this policy’s Change of Control exclusion, as least as construed by the insurers here, the mere presence of the single post-merger act allegation would be sufficient to preclude coverage not only for the post-merger act but also for all of the 99 pre-merger wrongful acts.

Keep in mind, Judge Freeman’s ruling held open the door for the insurers to come back and argue that ALL of the coverage is precluded if they can later show that post-merger acts are alleged. Fair minded readers may well question whether this is language appropriately addresses the insurer’s objective of precluding coverage for post-merger conduct. The exclusion seemingly makes it possible for the insurer to dodge liability even for pre-merger wrongful acts if only one post-merger wrongful act is alleged.