chinaAs I learned during my recent visit to the country, just about everything about China is big. It is the world’s most populous country. China leads the world’s economic growth by size and speed. It is also one of the world’s largest and fastest-growing insurance markets. According to a June 10, 2015 Law 360 article entitled “A Primer on Insurance Underwriting in China” (here, subscription required) by Jiangxiao Hou, Qiamwei Fu and Jose Umbert of the Zelle Hoffman Voebel & Mason law firm, China not only has the world’s second largest economy by GDP, but it has the world’s fourth largest insurance market, and by 2020 it is expected to become the world’s third largest insurance market (following the U.S. and Japan).

 

In other words, China represents a tremendous opportunity to the global insurance industry. Those of us involve in working with policyholders on their insurance requirement find on almost a daily basis that increasing numbers of companies and firms located throughout the world operations or exposures in or related to China that require insurance solutions. For that reason, it is going to be increasingly imperative for just about everyone, regardless of geographic location, to develop some familiarity with the insurance environment in China. The insurance market in China has a number of important characteristics, with implications from a regulatory, underwriting and claims handling perspective. And as the memo’s authors note, “certain customary practices in Western countries to not necessarily have the same ramifications.”

 

First, the key characteristics of the Chinese market. The regulatory framework is, according to the memo’s authors, “constantly evolving.” The regulatory regime involves laws issues by the National People’s Congress, regulations issued by the State Counsel, and “a myriad of rules and guidelines issued by the Insurance Regulatory Commission [the CIRC].” The CIRC is the primary insurance regulator, and has issued voluminous insurance regulators.

 

A critical consideration for the global insurance industry, the Chinese insurance regulations provide a legal person or entity in China can only obtain domestic coverage from an insurer registered with the CIRC. In addition, insurance companies with a 25 percent or more of foreign shareholdings are deemed “foreign-invested” and are subject to more detailed regulations, particularly with respect to ownership, product offerings and product applications, branch approvals, reporting and disclosures.

 

From an underwriting perspective, the insurance regulations provide detailed requirements for the registration of insurers and for product and rate filings. Insurance forms, insurance clauses and premium rates for many insurance products must be approved by the CIRC before use. The insurance regulations also contain requirements analogous to the “plain English” requirements applicable in many states in the U.S., specifying that an insurer is required, for example, to “clearly explain” exclusion provision, with the proviso that an exclusion provision that is not properly explained will be voided.

 

A basic principle of Chinese Insurance law is the “good faith requirement.” This requirement applies to both insurers and policyholders. From an underwriting perspective, the good faith requirement applies to the application process and requires an applicant to “make an honest disclosure” in response to an insurers inquiry (although the principle is limited only to the specific matters about which the insurer inquires, and the burden is on the insurer to prove the scope of its inquiries). An insurer has a right to cancel a policy if an applicant intentionally or in gross negligence fails to make an honest disclosure. Where the nondisclosure is intentional, the insurer it not liable to pay indemnity; if the nondisclosure is grossly negligent and the matter not disclosed has an effect on the insured event, the insurer is not required to pay indemnity but must return the premium.

 

The good faith principle also applies to both the insurer and the insured in the claims handling process. The policyholder must provide claim information in a timely and truthful way, consistent with the requirements of the good faith principle.  If a policyholder lodges a fraudulent claim, the insurer has the right to terminate the insurance contract. For the insurer, the insurance regulations specify a structured schedule for claims adjustment, which is also subject to the good faith principle.

 

The insurer must make a “timely” coverage determination, which in complex cases (and absent a provision in the policy to the contrary) is presumed to be within thirty days of completion of gathering all claims-related information. The determination of when information gathering is complete is subject to the good faith principle. The regulations also specify when payment must be made once the claims determination process is complete.

 

The authors note that “certain customary practices in Western countries do not necessarily have the same ramifications in China. For example, in many Western countries it is a standard practice at the outset of a claim for the insurer to issue a letter reserving its reserving its coverage defenses and in particular reserving its right to deny coverage for the claim should information uncovered in the course of claims handling reveal a basis for doing so. This practice is not a customary practice in China and “there are no legal ramifications to the issuance or nonissuance of a ROR.”

 

In short, China presents significant opportunities but it is critically important for those participating insurance transactions in China to understand both the requirements for disclosures in the underwriting process and the requirement for information and timeliness in the claims handling process.

 

D&O Liabilities in China: The potential liabilities of corporate directors and officers are of course dependent on the requirements of applicable law. That means that corporate officials’ liability exposures can vary from state to state. There are even greater variations from country to country. In a global economy, questions about the potential liability of directors and officers in non-U.S. countries arise with increasing frequency. Given China’s huge and growing role in the global economy, questions about the potential liability of directors and officers under Chinese law are increasingly frequent.

 

For that reason, readers may be interested in reviewing this May 8, 2015 article entitled “D&O Liability Insurance: Legal Issues under PRC Law” (here) by Jia Hui of the DeHeng Law Offices. The article provides a good overview of the basic legal duties and liability exposures of directors and officers under Chinese law. As the article points out, in light of the various accounting scandals involving Chinese companies that have arisen, these considerations are increasingly important.

 

EPL Risk and Applicant Background Checks: On an entirely different note, Inside Counsel has an interesting June 11, 2015 article about the rising numbers of EPL claims arising out of employer background checks (here). According to the article, “these lawsuits present an unanticipated and significant exposure for insurers.” The article, which is clearly written from the insurer perspective and has insurers in mind, says that insurers “protect themselves by including specifically targeted exclusions that should eliminate this exposure altogether.”

 

From my perspective, given the apparently rising importance of these types of claims, it will be very important for policyholders to ensure that the EPLI carriers do not include exclusions precluding coverage for these types of claims.

 

 

third circuitThe traditional Insured vs. Insured exclusion found in many D&O insurance policies is a frequent source of claims disputes, particularly in the bankruptcy context. As its name suggests, the Insured vs. Insured exclusion precludes coverage for claims brought by one Insured against another Insured. The typical Insured vs. Insured exclusion includes a provision (often referred to as a coverage carve-back) that preserves coverage for claims brought by a trustee in bankruptcy or by other representatives of the bankrupt estate.

 

While this carve-back provision broadly preserves coverage for many types of bankruptcy-related claims that might arise against the current or former directors or officers of a bankrupt company and that might otherwise be excluded by operation of the Insured vs. Insured exclusion, there is one type of claim that can arise for which the typical policy language does not preserve coverage – that is, a claim against the company’s former directors and officers brought by the bankrupt company as debtor- in- possession.

 

Along those lines, a June 5, 2015 decision by the Third Circuit, applying New York law, affirmed a district court ruling that a lawsuit initiated by a bankrupt company as debtor-in-possession against certain of its former directors and officers was precluded from coverage by the Insured vs. Insured exclusion in the company’s D&O insurance policy. A copy of the Third Circuit’s opinion can be found here.

 

Background

Robert Redmond was an officer of Industrial Enterprises of America, Inc. (“IEAM”). In 2009, IEAM filed for bankruptcy protection. In 2011, IEAM, acting as debtor-in-possession, brought an adversary proceeding against Redmond and certain other former IEAM executives and employees alleging that they had engaged in a fraudulent scheme to manipulate IEAM’s share price. In 2013, a Chapter 11 trustee was appointed to pursue IEAM’s claim.

 

Redmond sought to have IEAM’s D&O insurer fund his defense in the adversary proceeding. The insurer took the position that coverage for the claim was precluded by the policy’s Insured vs. Insured exclusion [strictly speaking, for purposes relevant to this case, the exclusion was actually a Company vs. Insured exclusion], which provides that the insurer is not liable of losses arising from any “Claim brought or maintained by, on behalf of, or in the right of …the Company in any respect.” The term “Company” was defined as IEAM, its subsidiaries, and “any such organization as debtor-in-possession.”

 

Redmond filed a coverage lawsuit against the insurer. The insurer moved to dismiss Redmond’s complaint, arguing that coverage was precluded by the Insured vs. Insured exclusion. The district court granted the insurer’s motion to dismiss. Redmond appealed.

 

The June 5 Opinion

In a short June 5, 2015 opinion captioned as “Not Precedential” and written by Judge Patty Shwartz for a three judge panel, the Third Circuit affirmed the district court’s dismissal.

 

The appellate court said that the phrase “brought … by” as used in the Exclusion unambiguously means “commence” and that under the Exclusion the insurer is not liable for suits commenced or “brought” by the “Company.” The fact that the Chapter 11 trustee has been substituted as the plaintiff and is now pursuing the action on behalf of IEAM “does not mean the trustee initiated the suit or change the fact that IEAM commenced or ‘brought’ the action.” The “plain language of the Exclusion,” the Court said, allows the insurer to deny coverage for Redmond’s defense expenses. The appellate court concluded that the district court had not erred in dismissing Redmond’s complaint.

 

Discussion

The language of the Insured vs. Insured exclusion has changed over the years. In particular, the provision within the exclusion preserving coverage for claims brought against directors or officers by a bankruptcy trustee or other representative of the bankruptcy estate has evolved. For example, it is now fairly standard for the bankruptcy trustee carve-back provision in the Insured vs. Insured exclusion to preserve coverage for claims brought by a creditors’ committee.

 

While this bankruptcy trustee carve-back provision of the Insured vs. Insured exclusion has evolved, it is still rare for the carve-back provision to include language preserving coverage for claims brought by the bankrupt company as debtor-in-possession – even though it is now fairly standard, as was the case here, for the policy to include the company as debtor-in-possession within the meaning of Company. As a result, and as was the case here, the Insured vs. Insured exclusion operates to preclude coverage for claims brought against the former directors and officers of a bankrupt company by the company as debtor-in-possession.

 

This issue could be pretty easily cleaned up by including the company as debtor-in-possession in the list of bankruptcy-related claimants for whose claims coverage is carved back as an exception to the exclusion.  The insurers’ concern with this relatively expedient solution is the possibility of collusive claims. As the Ninth Circuit noted in the Visitalk case (which I discussed here), if there were to be coverage for claims by the company as debtor-in-possession, the policy would

 

create a perverse incentive for the principals of a failing business to bet the dwindling treasury on a lawsuit against themselves and a coverage action against their insurers, bailing the company out with the money from the D & O policy if they win and giving themselves covenants not to execute if they lose. That is among the kinds of moral hazard that the insured versus insured exclusion is intended to avoid.

 

Not to minimize the collusive possibilities to which the Ninth Circuit referred, but there is a legitimate concern that without policy recognition in some way for debtor-in-possession claims, individuals could be left without insurance for claims of a kind for which D&O policies are intended to provide coverage.

 

There are, in fact, D&O insurance policies available in the current marketplace that attempt to address the problem of debtor-in-possession claims. For example, one policy’s list of the bankruptcy-related claimants for whose claims coverage is carved back include “a Claim by the Entity as Debtor-in-Possession after such Examiner, Trustee, Receiver has been appointed.” The prerequisite for the availability of coverage under this carve back for the appointment of an examiner or trustee does represent some check against the collusive possibilities about which the Ninth Circuit was concerned.

 

Whether or not this particular formulation is sufficient to preclude the possibility of collusive claims, it strikes me as a step in the right direction toward protecting against the possibility that individuals could otherwise be left without coverage for claims of a kind for which these policies were intended to provide protection.

 

One final observation about this particular coverage problem is that whether or not the primary D&O insurer will agree to provide a coverage carve back in the I v I exclusion for debtor in possession claims, an insured company may be able to purchase an excess Side A policy providing “difference in condition” protection and that either does not contain an I v. I exclusion or has one that is very narrowly circumscribed.

virginiaFederal prosecutors have come in for considerable criticism over their failure to press criminal charges against executives of financial institutions whose stumbles led to the global financial crisis. As Southern District of New York Judge Jed Rakoff pointed out in his blistering January 9, 2014 opinion column in The New York Review of Books (here), “not a single high-level executive has been successfully prosecuted in connection with the recent financial crisis.”

 

Rakoff’s statement is not quite accurate, as there was at least one prosecution of a Wall Street banker. But while it may be true that few high-level Wall Street executives were prosecuted, it is not true that there were no criminal prosecutions. Prosecutors did file criminal actions against some financial executives, albeit largely against individuals associated with smaller institutions. In at least some cases, these prosecutions resulted in criminal convictions. On June 5, 2015, the Fourth Circuit Court of Appeals affirmed the convictions of three former officers of the failed Norfolk, Virginia-based Bank of the Commonwealth, in connection with the bank’s September 2011 failure. The Fourth Circuit’s opinion in the case can be found here.

 

Background

The Bank of the Commonwealth of Norfolk, Virginia failed on September 23, 2011. In connection with the bank’s failure, the FDIC sustained losses of approximately $333 million. As discussed in a prior post (here, second item), on July 11, 2012, a grand jury returned an indictment (here) against the bank’s former Chairman and CEO, Edward Woodard, Jr.,  for conspiracy to commit bank fraud, bank fraud, false entry in a bank record, multiple counts of unlawful participation in a loan, multiple counts of false statement to a financial institution, and multiple counts of misapplication of bank funds. Three other former officers of the bank and two of its customers are charged with a variety of related charges. The FBI’s July 12, 2012 press release regarding the indictment can be found here.

 

As described in its January 9, 2013 press release (here), the SEC separately filed a civil enforcement action against Woodard, Cynthia Sabol, the bank’s CFO, and Stephen Fields, the bank’s former executive vice president. The SEC’s complaint, which can be found here, asserts claims for securities fraud against the three defendants for alleged “misrepresentations to investors by the bank’s parent company.” The SEC charged the three “for understating millions of dollars of losses and masking the true health of the bank’s loan portfolio at the height of the financial crisis.” The SEC alleges that Woodard “knew the true state” of the bank’s “rapidly deteriorating loan portfolio,” yet he “worked to hide the problems and engineer the misleading public statements.” Sabol also allegedly knew of the efforts to mask the problems yet signed the disclosures and certified the bank’s financial statements. Fields allegedly oversaw the bank’s construction loans and helped mask the problems. As discussed here, the SEC ultimately reached settlements with each of the defendants, in which the individuals agreed to an officer bar and to pay fines.

 

Trial in the criminal case began on March 19, 2013, against Woodard;  Fields; Troy Brandon Woodard, who is Woodard’s son and was the bank’s Executive Vice President and Commercial Loan Officer; and two other defendants. Trial in the case lasted ten weeks. The government called 48 witnesses and entered over 600 exhibits into evidence. The defendants called 44 witnesses and entered over 400 exhibits. All five defendants testified on their own behalf. On May 24, 2013, the jury returned guilty verdicts against both of the Woodards and Fields.

 

Woodard was convicted of conspiracy to convict bank fraud; making a false entry in a bank record; four counts of unlawful participation in a load; two counts of making a false statement to a financial institution; two counts of misapplication of bank funds; and bank fraud. Fields was convicted of conspiracy to commit bank fraud; two counts of making a false entry in a bank record; making a false statement to a financial institution; and two counts of misapplication of bank funds. Brandon Woodard was convicted of conspiracy to commit bank fraud; and three counts of unlawful participation in a loan. Woodard was sentenced to 23 years imprisonment. Fields was sentenced to a 17-year imprisonment term. Brandon Woodard was sentenced to eight years imprisonment.

 

All three appealed their convictions and Brandon Woodard appealed his sentence. On appeal, Fields challenged time limitations the district court placed on his direct testimony. Woodard challenged the sufficiency of evidence against him and the trial court’s exclusion of certain evidence. Brandon Woodard also challenged the sufficiency of the evidence and also challenged the trial court’s use of sentence enhancements in fixing the period of his imprisonment. All three defendants challenged various evidentiary rules the district court made during the trial.

 

The June 5 Opinion

In an unpublished June 5, 2015 opinion written by Judge Dennis Shedd for a unanimous three-judge panel, the Fourth Circuit affirmed the convictions and Brandon Woodard’s sentence.

 

With respect to Fields’s contention that his direct testimony was cut short, the appellate court noted that “throughout the examination, the court warned counsel repeatedly that he was straying into irrelevant or marginally relevant lines of questioning.” The appellate court also noted that Fields’s direct examination lasted over seven hours and was the longest direct examination of any witness in the case –longer than that of the other co-defendants who were charged with a larger number of substantive counts. Fields’s counsel also failed to avail himself of the opportunity for redirect examination. The appellate court concluded in light of these considerations, the district court did not abuse its discretion in limiting the duration of Fields’s testimony.

 

With respect to Woodard’s and Brandon Woodard’s contention that the evidence against them was insufficient, the appellate court found that the government “presented ample evidence” in support of the conspiracy to commit bank fraud charge. In support of this conclusion, the court reviewed trial testimony showing how Woodard collaborated with various bank customers to try to help Brandon Woodard with various loan repayment difficulties he was having. The appellate court found that the testimony was sufficient to sustain the convictions.

 

Discussion

This case is not the only one in which former executives of a failed bank were criminally prosecuted. Other failed bank executives were also prosecuted (refer, for example, here and here). So as I said at the outset, it is not true that there were no criminal convictions in the wake of the financial crisis. However, when you look at the enormous resources the government deployed just to snag these relatively lower level individuals while no charges were brought against the Wall Street executives whose actions nearly brought down the entire global financial system, you do start to wonder what is going on.

 

On the other hand, when you look at the enormous effort that was required just to convict these smaller profile defendants, you can imagine what might have been required if the government had tried to go after some of the bigger fish. Former Attorney General Eric Holder may have had that kind of concern in mind when he said while testifying before Congress in 2013 that “I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them.”

 

In any event, this appellate court ruling does have a little bit of an end of an era feel about it. The final remnants from the financial crisis are slowly winding down. While the global financial system is still not yet fully recovered from the crisis, in many ways the world has moved on.

 

I did note while preparing this post that though the bank failure peak is now well in the past, banks are continuing to fail, albeit at a much reduced pace. The FDIC’s failed bank list shows that so far in 2015, five banks have failed (though only once since the end of February). There may yet be further bank failures. But by and large the bank failure wave seems to have just about played out. The time may soon come to close the book on the financial crisis.

FIFAThe U.S. Department of Justice’s blockbuster announcement in late May that U.S. prosecutors have indicted fourteen defendants on corruption charges involving activities of the International Federation of Football (FIFA) and related regional member organizations captured news headlines around the world. The story has continued to dominate the news, as new details about the scandal have continued to emerge. But while the press coverage has been comprehensive, it has not always been entirely precise. Among other things, contrary to the suggestion in many domestic U.S. press reports, the DoJ’s massive criminal indictment does not include any charges under the Foreign Corrupt Practices Act (FCPA). However, at least according to some commentators, based on the allegations made to date, certain companies could find themselves facing FCPA-related scrutiny.

 

The Department of Justice’s May 27, 2015 press release concerning the indictment can be found here. The government’s 161-page indictment itself can be found here. The Wall Street Journal’s May 28, 2015 front page article describing the allegations in the indictment and related government court filings can be found here.

 

Part of the confusion about the possible involvement of FCPA-related allegations has to do with the fact that the core misconduct alleged is the making of improper payments to FIFA officials by representatives of sports marketing companies.   According to the DoJ’s press release, the criminal defendants are alleged to have “systematically paid and agreed to pay well over $150 million in bribes and kickbacks to obtain lucrative media and marketing rights to international soccer tournaments.”

 

But though the FIFA corruption-related indictment includes improper payment allegations, the criminal action is not a FCPA prosecution, as the Southern Illinois Law School Professor Mike Koehler points out in a June 1, 2015 post on his FCPA Professor blog (here). Rather, as the DoJ summarized in its press release about the indictment, the criminal action involves charges of racketeering, wire fraud and money laundering conspiracies. Some of the defendants were charged with obstruction of justice and tax evasion.

 

As Professor Koehler notes, the FCPA does not apply to every type of bribe. The FCPA’s anti-bribery provisions apply only to bribe payors and not bribe recipients. In addition, in order for there to be an offense within the ambit of the FCPA, the improper payment must have been made (or attempted to be made) to a “foreign official.” The FIFA officers involved do not, according to Koehler, appear to meet the statute’s definition of foreign official.

 

While the prosecutors are not relying on the FCPA, they relying a weapon that if they are able to use successfully here could broaden the U.S. authorities’ power to pursue corruption claims globally. As Wayne State Law Professor Peter Henning discusses in a June 1, 2015 post on his White Collar Watch blog on the New York Times website (here), the U.S. prosecutors’ indictment, made largely in reliance on the Racketeering Influenced and Corrupt Organizations (RICO) Act, will test the extent to which the U.S. law can be applied to conduct much of which took place outside of the U.S.

 

RICO, according to Professor Henning, gives the prosecutors “the firepower to bring all the defendants together in a single case by asserting that there was a pattern of rampant corruption tying the defendants together into a larger scheme.” The prosecutors are essentially alleging that the indicted individuals were using FIFA as a criminal enterprise.

 

As Professor Henning notes, the lower U.S. courts have struggled since the U.S. Supreme Court issued its 2010 decision in Morrison v. National Australia Bank to determine whether or not Congress intended RICO to apply extraterritorially. The criminal defendants will likely challenge the U.S. authorities’ ability to rely on RICO. As Henning notes, “If RICO can be added to a case involving multiple defendants to claim that they engaged in a pattern of misconduct, then the Justice Department will indeed have a very big stick to attack corruption almost anywhere.”

 

And even though the allegations thus far may not support FCPA-related allegations, the conduct alleged could, Professor Koehler notes, “result in FCPA scrutiny for certain companies.”

 

In particular, the government’s indictment includes allegations of bribery involving an unnamed U.S. sportswear company. According to the Wall Street Journal, the company referred to in these “barely veiled references” is Nike, Inc. Nike is not named in the indictment and neither it nor any of its executives have been charged with wrongdoing. However, as the Wall Street Journal detailed in a June 4, 2015 front page article (here), the indictment and related charging documents allege that up to $30 million from the sponsorship pact the clothing company signed in 1996 with the Brazilian soccer federation was paid through a side deal between the company and a middleman. The middleman used part of that money to pay bribes, according to the indictment. Jose Hawill, the owner of the middleman, Traffic Brazil, has admitted to crimes including money laundering, fraud and extortion.

 

These allegations relating to Nike, as more fully detailed in the FCPA Professor blog post linked above, could, according to Professor Koehler, “potentially implicate the FCPA’s books and records and internal controls provisions.”

 

These allegations not only, according to the Journal, “cast a long shadow” over Nike, but they also raise questions – rightly or wrongly — about other sponsorship companies. Let me emphasize here that insofar as I know, there has been no suggestion whatsoever that any other sponsorship companies have been involved in any misconduct. Nevertheless, as the Journal put it, the allegations in the FIFA scandal are “a big headache” for the several companies that have in recent years paid millions of dollars for marketing rights at the FIFA-sponsored soccer events. According to the Journal, six companies — Adidas, Coca-Cola, Emirates, Hyundai, Sony and Visa – paid nearly $190 million to FIFA to be official marketing sponsors for the 2014 World Cup. A second tier of sponsors paid an additional $171 million in connection with the World Cup. A May 28, 2015 Business Insider article detailed in the sponsors reactions to the news of the scandal can be found here.

 

There are yet other firms that have found themselves unfortunately associated with the unfolding FIFA scandal, including in particular the banks that are alleged to have funneled the cash associated with the improper payments. A detailed section of the indictment captioned “The Centrality of the U.S. Financial System” states that the “the defendants and their co-conspirators relied heavily on the United States financial system in connection with their activities,” adding that “this reliance was significant and sustained and was one of the central methods and means through which they promoted and concealed their schemes.”

 

According to the indictment, bribes ranging in the millions of dollars allegedly found their way between accounts at Citibank, JPMorgan, HSBC, Barclays and other banks. According statements of the U.S. Attorney for the Eastern District of New York, where the indictment was filed, as quoted in a May 28, 2015 International Business Times article (here), the banks are being probed as part of the continuing investigation, adding that “It’s too early to say whether there is any problematic behavior, but it will be part of our investigation.” According to a May 28, 2015 Daily Mail article about the allegations involving the banking institutions (here), Britain’s Serious Fraud Office is looking into whether any of the alleged corruption took place on British soil or involved any UK firms or individuals.

 

Another organization that has found itself associated with the unfolding FIFA scandal is KPMG, the global accounting and auditing firm. KPMG acted as FIFA’s auditor. FIFA also audits a number of the regional member organizations that operate under FIFA’s umbrella. According to an interesting June 5, 2015 Marketwatch article entitled “FIFA Auditor KPMG Totally Missed the Soccer Scandal” (here),  by Francine McKenna, the author of the re: The Auditors blog (here), KPMG also prepares an audited summary at the end of each of the four-year World Cup cycles. In addition KPMG represented both the Russian and the Qatari organizing committees (although Qatar switched to E&Y in 2011). McKenna’s article quotes several commentators as stating, among other things, that KPMG should have caught and called out the illegal activities. A June 3, 2015 CFO.com article (here) raises many of the same questions concerning KPMG.

 

While many observers are shocked by the wrongdoing alleged in the FIFA scandal, others have been more outraged by the prosecution itself. For example, in a statement on the Kremlin website, Russian President Vladimir Putin charged that the criminal allegations are part of a U.S. conspiracy for world dominion; accused the U.S. of “persecution;” and asserted that criminal prosecution was “just one more brazen attempt [by the U.S.] to spread its jurisdiction to other states.” Putin also asserted with respect to the individual defendants named in the indictment that “aren’t U.S. citizens, and if anything happened, it didn’t happen on the territory of the U.S.”

 

However, as Professor Koehler notes, that while the indictment does refer to conduct outside the U.S., much of the conduct is also alleged to have taken place inside the U.S. or to involve U.S.-affiliated individuals and entities:

 

As to the core alleged bribery scheme, three of the defendants are U.S. citizens; various of the regional soccer associations implicated have offices in the U.S.; several of the intermediate sports marketing companies have headquarters, offices or affiliates in the U.S.; and the indictment contains several allegations concerning use of U.S.-based bank accounts, phone calls from the U.S.; and in-person meetings in the U.S. in furtherance of the alleged bribery scheme.

 

One might argue not only that Putin has challenged the criminal prosecution out of concern for where it might lead with respect to the 2018 World Cup, now scheduled to take place in Russia, but also that  he clearly prefers a world in which bribes can be paid and received with impunity and without scrutiny.

 

One question I have received over the past few days has to do with what the potential D&O insurance implications might be from these events. The short answer, without further information about what D&O insurance protection the various organizations might carry (if any), is that it is just hard to tell. A typical domestic U.S. D&O insurance policy will include within the definition of a covered “Claim” the initiation of a criminal action following indictment. However, the 14 individuals who were named in the recent indictment represented a variety of different organizations and institutions, only some of which are domiciled in the U.S.

 

Nine of the indicted individuals are current or former officers or directors of FIFA or CONCACAF, the regional confederation for North America, South America, and the Caribbean. Several of the individuals were officers or directors of both FIFA and CONCACAF. FIFA is an international body and entity registered under Swiss law and headquartered in Zurich. CONCACAF is incorporated in Nassau, Bahamas, with its current headquarters location in Miami, Florida. (Before 2012, it was headquartered in New York). Because any D&O insurance policy FIFA might carry likely was issued in Switzerland, it is a little more difficult for me to assess what its terms might provide. Any separate coverage CONCACAF might carry likely would have been issued in the U.S. In any event, a challenging issue that will face those who were officers or directors of both FIFA and CONCACAF, is which policy (if any) should respond to the allegations that have been made against them.

 

In addition to the nine current or former FIFA or CONCACAF officials, the indictment also named five other individuals, four who were employed by sports marketing firms located in Argentina, Brazil and the U.S., while a fifth individual was employed by broadcasting-related firms. These individuals will have to look to their respective corporate employer’s D&O insurance policies (if any). The extent of protection available to these individuals may well depend on where the policies were issued, as terms and conditions often vary by country. Typically, however, private company D&O insurance policies include the initiation of a criminal action by an indictment within the definition of a covered Claim.

 

All of the individual defendants are alleged to have engaged in intentional criminal misconduct. The typical D&O policy will contain an exclusion precluding coverage for criminal or fraudulent misconduct. However, most modern D&O policies will provide that the precluded conduct must be established by an “adjudication” in order for the exclusion to be triggered. As long as the allegations are merely alleged but unproven, the exclusion will not be triggered. However, a conviction or even a guilty plea would likely trigger the exclusion.

 

As a result, all of these individuals will face the potential problem that if they are convicted (or even if they plead guilty), their respective D&O insurers would, depending on the nature of the charge for which they were convicted,  likely have the right to seek recoupment from them of any amounts the insurers have paid in their defense (as I discussed in a recent post, here). In that regard, it is worth noting that in addition to the fourteen individuals who were named as defendants in the recent indictment, the DoJ’s press release also refers to four individuals and two entities that between 2013 and 2015 each pled guilty charges presented against them in a criminal information. There is no way to tell whether these individuals, affiliated with FIFA, CONCACAF and sports marketing firms, sought to have their respective organizations’ carriers pay for their criminal defenses. To the extent the carriers did pay any amount, and to the extent the criminal pleas triggered any potentially applicable policy exclusions, the carriers may have the right to seek to recoup those amounts.

 

A more interesting question from a D&O insurance standpoint will be whether or not there will be any follow on civil litigation. Because FIFA and CONCACAF are themselves membership organizations rather than commercial stock corporations, it is not immediately apparent who the potential claimants might be (except perhaps their respective affiliated membership organizations). The possibility of either criminal proceedings or civil litigation involving the various sponsors, banks and accounting firms who have been drawn into this scandal presents a different set of issues. While the possibility of these firms getting drawn into the legal proceedings at this point seems unlikely, the possibility at least raises a D&O insurance underwriting issue for the firms in question.

 

I will say this, that while the allegations in the U.S. indictment do not relate directly to the selection of World Cup sites for 2018 and 2022, and while much of the investigation has yet to play out (including in particular the ongoing investigation in Switzerland of the site selections for the 2018 and 2022 World Cups), if you wanted an example of how a corrupt process can produce distorted results, you wouldn’t need to look much further than the selection of Qatar as the site for the 2022 cup. Almost from the moment it happened, the Qatar site selection has been mired in controversy owing (among many other things) to questions about the suitability of the site for the event. In particular, the sheer impossibility of holding the event in Qatar during the summer months has caused innumerable problems, as a result of which the event has now been shifted from its traditional June and July time frame to a mid-November to mid-December time frame – which will of course wreak havoc with the schedule of most of the domestic soccer leagues.

 

This is all too bad, because as the 2014 event in Brazil showed, the World Cup is one of the world’s great spectacles. As a soccer fan, I find all of this news and controversy truly dismaying.

 

More About the 2008 Beijing Olympics: As long as I am passing along interesting links to the FCPA Professor blog, I though I should add one more link pertinent to an item I posted last week about the allegedly corrupt sponsorship activities in which BHP Billiton was implicated in connection with the 2008 Beijing Olympics. While in my blog post I suggested – and quoted others as saying — that the SEC’s enforcement action against BHP Billiton represented an aggressive use of the agency’s enforcement authority under the FCPA, Professor Koehler takes a different view. In a June 4, 2015 blog post (here), he writes that “while the BHP Billiton action is problematic on a number of levels… the enforcement approach in BHP Billiton was hardly unique.  The SEC often charges or finds books and records and internal controls violations in the absence of anti-bribery charges or findings.” Koehler promises to provide a future post in which he will further detail his reasoning.

 

More About SEC Chair Mary Jo White: In my blog post last week in which I detailed Senator Elizabeth Warren’s scathing letter criticizing SEC Chair Mary Jo White, I noted that many of the charges Warren raised failed to take into account the fact that several of the specific items for which Warren criticized White are only within the purview of the Commission as a whole, and not within authority of the SEC Chair acting alone.

 

A front-page June 4, 2015 article in the Wall Street Journal article entitled “SEC Bickering Stalls Mary Jo White’s Agenda” (here) highlights how sharp political divisions among the various individual SEC Commissioners has not only poisoned the atmosphere at the agency but undermined White’s agenda and produced gridlock – the very gridlock for which Senator Warren lambasted White. A June 5, 2015 New York Times article (here) details how political divisions at the Commission nearly capsized the agency’s enforcement action against Computer Sciences Corporation. In a very interesting June 4, 2015 post on his TheCorporateCounsel.net blog (here), Broc Romanek asks, in a question that was not meant to be rhetorical, “Is Partisan Politics Destroying the SEC?”

 

Whether or not criticisms of White are warranted, I think it is patently unfair to question her leadership without acknowledging the contentious dynamic that has undermined her efforts. Senator Warren’s failure to acknowledge the problems arising from the agency’s sharp partisan divides is all the more surprising given that the Democratic Senator from Massachusetts in in the same political party as the President who appointed White.

 

More About Proxy Put Litigation: In an earlier post (here), I wrote about how the presence of provisions in corporate loan agreements requiring the acceleration of the debt maturity in the event of a management change has been producing D&O litigation. A June 5, 2015 memo from the Fried Frank law firm (here) takes at looks at these kinds of provisions – often called “proxy puts” – as well as the recent litigation that has surrounded the provisions.

 

According to the memo, all too often insufficient care is taken to distinguish between two kinds of corporate loan provisions, a simple “proxy put” and what the memo calls a “dead hand proxy put.” Both kinds require the acceleration of the debt maturity in the event of a change in control of the borrower’s board. A “dead hand” provision adds the additional requirement that any director elected as a result of an actual or threatened proxy contest will be considered a non-continuing director for purposes of the proxy put. The memo states proxy put provisions have frequently been used without controversy. Dead hand proxy puts, however, are now being challenged. While the memo contends that both proxy puts and dead hand proxy puts can be appropriate, the memo suggests that companies consult with their counsel, and identifies the factors that company’s should take into account, including in particular the motivations and interests of the lending  bank involved.

 

Warren Buffett’s Management Model: Warren Buffett’s investment style and philosophy have been admired and emulated for many years. But as my good friend and George Washington University Law Professor Larry Cunningham contends, Buffett’s management style is also worthy of study and emulation. In an interesting recent Wake Forest University Law Review article entitled “Berkshire’s Disintermediation: Buffett’s New Managerial Model” (here), Cunningham argues that “While Buffett’s legacy to date has been to lead two generations of value investors, Berkshire’s radically ingenious disintermediation has the potential to shape the next two generations of value managers.”

 

Cunningham is the author of the recent book “Berkshire Beyond Buffett: The Enduring Value of Values,” which I reviewed here.

 

fourthcircuitIt sometimes comes as a surprise to some policyholders that D&O carriers contend that they have the right to try to recover amounts they have paid as defense expenses if it turns out that coverage for a claim is precluded by a policy exclusion. However, an insurer’s right of defense expense recoupment is by now fairly well-established, at least under certain circumstances and at least where the policy expressly provides the carrier with the right to seek recoupment. As discussed further below, it is still relatively rare for a carrier to seek to recoup amounts it has paid out.

 

The right of a carrier to seek recoupment was reaffirmed by a recent appellate court ruling. In a May 27, 2015 opinion (here), the Fourth Circuit affirmed the ruling of district court that the guilty pleas of four employees of Protection Strategies, Inc. (PSI) triggered several policy exclusions and gave the company’s insurer the right to seek recoupment of the defense expenses the carrier had previously paid. A June 4, 2015 post about the Fourth Circuit’s opinion on the Wiley Rein law firm’s Executive Summary blog can be found here.

 

Background

As discussed in greater detail here, in early 2012, PSI was served with several subpoenas and search warrants. In June 2012, PSI received a letter from the U.S. Attorney for the Eastern District of Virginia stating that the U.S. Attorney and the DoJ were investigating PSI’s participation in a Small Business Administration loan program.

 

In March 2013, four PSI executives entered into plea agreements in the Eastern District of Virginia. PSI’s former CEO Keith Hedman pleaded guilty to a criminal information charging him with major fraud against the United States and conspiracy to commit bribery. Among other things, in his plea agreement Hedman stipulated that his actions were done “willfully, knowingly and not because of accident, mistake or innocent reasons.” Three additional PSI officials pled guilty to conspiracy to commit fraud and major fraud against the United States. Criminal judgments were subsequently entered against each of the four individuals and the four were sentenced to terms of incarceration.

 

The D&O coverage section of PSI’s private company management liability insurance policy contained several exclusions, including the following:

 

This policy shall not cover any Loss in connection with any Claim …

(a) arising out of, based upon, or attributable to the gaining of any profit or advantage or improper or illegal remuneration if a final judgment or adjudication establishes that such Insured was not legally entitled to such profit or advantage or that such remuneration was improper or illegal;

(b) arising out of, based upon or attributable to any deliberate fraudulent act or any willful violation f law by an Insured if a final judgment or adjudication establishes that such act or violation occurred;

….

(d) alleging, arising out of, based on or attributable to any facts or circumstances of which an Insured Person had actual knowledge or information of, as of the Pending or Prior Date set forth in Item 6 of the Declarations as respects this coverage section, and that he or she reasonably believed may give rise to a Claim under this policy.

 

The policy also states that in determination the applicability of Exclusions (a) and (b), “the knowledge possessed by, or any Wrongful Act committee by, an Insured Person who is a past or current [chief executive officer] …shall be imputed to the Company.”

 

In connection with its purchase of the management liability insurance policy, PSI had provided the carrier with a February 15, 2011 Warranty Letter signed by Hedman which represented that “no person or entity proposed for insurance under the policy referenced above has knowledge of information of any act …which might give rise to a claim(s), suit(s), action(s) under such proposed policy.” The warranty letter further stated that if any such “knowledge or information exists, then … any claim(s), suit(s) or action(s) arising from or related to such knowledge or information is excluded from coverage.”

 

Section 6 of the Management Liability Insurance Policy’s general terms and conditions states that the Insurer “shall pay defense costs prior to the final disposition of any claim,” but that “in the event and to the extent that the Insureds shall not be entitled to payment of such Loss under the terms and conditions of this policy, such payments by the Insurer shall be repaid to the Insurer by the Insureds.”

 

PSI’s D&O insurer contended that the guilty pleas triggered each of the three exclusions quoted above as well as the exclusion in the warranty letter. The insurer also argued that it was entitled to recoup the amounts that it had advanced for the company’s and the individual defendants’ attorneys’ fees. In the separate coverage lawsuit that followed, PSI and the D&O insurer filed cross-motions for summary judgment.

 

As discussed here, on April 23, 2014, Judge Liam O’Grady granted the insurer’s summary judgment motion and denied that of PSI, holding that the executives’ guilty pleas  triggered  each of the four separate exclusions on which the insurer relied, and that the insurer was entitled to recoup the defense fees that it had advanced. PSI filed an appeal.

 

The Fourth Circuit’s Opinion

In a short May 27, 2015 unpublished per curiam opinion, a three-judge panel of the Fourth Circuit affirmed the district court’s ruling, holding that PSI had failed “to establish reversible error in the district court’s judgment.”

 

The appellate court rejected PSI’s contention that the insurer had waived its right to rely on the policy exclusions; rejected the argument that the district court had impermissibly resolved issues of fact in concluding that the warranty letter exclusion applied; rejected PSI’s argument that the improper profit and fraud exclusions did not preclude coverage for the general counsel and two PSI employees, and holding that the guilty pleas of the company’s CEO and CFO triggered several exclusions in the applicable policy.

 

Finally, the appellate court rejected PSI’s challenge to the district court’s ruling that the insurer was entitled under the policy to right of recoupment “as unsupported by the record and otherwise without merit.”

 

Discussion

As I have noted before (here), while carriers often assert their right to seek recoupment, it is relatively rare for D&O insurers to actually seek recoupment.  That is largely because it is unusual in the context of a D&O claim for there to be final factual determinations, as most D&O claims settle long before the factual determinations are made. (Indeed, among the many reasons that securities suit rarely go to trial is the defendants’ concern that an adverse verdict would not only result in a finding of liability against them, but could also result in the loss of their insurance coverage.)

 

There is another practical reason that it is relatively rare for D&O insurers to attempt to recoup defense fees they have paid; that is, by the time an individual or company grinds all the way through a serious D&O claim, the person or company is usually broke. There is not much left for the insurer to go after. It is the very rare case where it is going to be enough left for it to be worth the insurer’s expense and time to try to recoup amounts paid out.

 

There is of course another reason why it is rare for D&O insurers to seek recoupment; in general, it is a poor public relations move for insurance companies to go around suing the persons they insure and seeking to recover amounts they have already paid. However, these constraints may be less compelling where as here the insureds’ senior executives have pled guilty to a massive multiyear effort to defraud the government.

 

Once the Court here concluded that the exclusions were triggered, it was always going to be difficult for PSI to persuade the court that the insurer was not entitled to recoupment. The courts are relatively uniform in affirming an insurer’s right to seek recoupment where express policy language provides for the insurer’s recoupment right. Indeed, as discussed here, in an April 2013 opinion, the Fourth Circuit affirmed a district court ruling that the guilty conviction of former Taylor Bean executive Lee Farkas triggered the D&O insurance policy’s conduct exclusions which in turn triggered the insurer’s policy right to recoup the defense fees it had previously paid.

 

The courts are more divided on the carrier’s right to recoupment where the sole basis on which the carrier asserts its right to do so is its own reservation of the right at the outset of the claim. Some courts have even taken the position that recoupment or reimbursement is prohibited in the absence of an express policy provision in the insurance contract preserving those rights.

 

These kinds of questions usually come up in the context of an insurer’s attempt to recoup amounts it has paid out as defense expenses. The questions are even more complicated when an insurer seeks to recover amounts it has paid out as indemnity – say, for example, where it has funded a settlement. Often the policy provisions providing an insurer with the right to seek recoupment –like the policy provision on which the insurer here relied — refer only to defense expenses.

 

For a discussion of a recent case where a federal district court (coincidentally, the Eastern District of Virginia, which is the same court as was involved in the PSI case) rejected a D&O insurers attempt to recoup amounts it had paid out in funding a prior settlement, refer here. Among other things, in rejecting the insurer’s right to recoupment of amounts paid in settlement, the district court judge noted that the policy’s recoupment provision referred solely to the insurer’s right to seek recoupment of defense expenses.

 

2015 ACI D&O Conference in New York: On September 17 and 18, 2015, the American Conference Institute will be holding is 19th Forum on D&O Liability in New York. This annual event features an all-star line-up of speakers and will be co-chaired by my friends, Diane Parker of AWAC and Doug Greene of the Lane Powell law firm. Readers of the D&O Diary are entitled to a $100 discount off registration if they mention discount code DOD100. Information about the event including registration instructions can be found here. The event brochure can be found here.

warren
Senator Elizabeth Warren
white
SEC Chair Mary Jo White

In an extraordinary 13-page letter dated June 2, 2015 sent to SEC Chair Mary Jo White, Senator Elizabeth Warren blasted White, whose leadership at the SEC the letter describes as “extremely disappointing.” Warren’s letter goes on to say to White that the Senator is “disappointed by the significant gap between the promises you made during and shortly after your confirmation and your performance as SEC Chair.” A copy Senator Warren’s June 2 letter can be found here.

 

The letter cites four specific areas in which the Senator says White has fallen short of promises the agency head made during her confirmation hearings or in subsequent communications to Congress.

 

First, the Senator’s letter takes White to task for the agency’s failure to implement final pay ratio disclosure guidelines. As I detailed in an earlier post (here), in September 2013, the SEC released for public comment proposed rules, mandated by Dodd-Frank, with details regarding CEO pay ratio reporting. The agency has yet to release final rules, and now according to the Office of Management and Budget, the rules may not be finalized until April 2016. (Warren’s letter is particularly critical of “misleading information” White gave to Warren’s office, before the most recent OMB report, in which the SEC reportedly said the final rules would be ready six months before the time the OMB now says they will be available.) In her letter, Warren said that “I cannot understand how and why this rule has been delayed for so long,” adding that she is “perplexed” by the difference between the finalization date now given by the OMB and the information the SEC previously supplied to Warren’s office.

 

Second, Senator Warren criticizes White for the SEC’s failure to require SEC settlements to include admissions of wrongdoing. According to information the agency provided Warren’s office, as of September 2014, in the vast majority of cases, the SEC continues to settle cases without requiring admissions of guilt. Of 520 settlements through September 2014, the SEC required admissions of guilt in only 19 cases. Of those 19, 11 involved “only a broad admission of facts specified by the SEC rather than requiring that these firms admit to violations of specific securities laws.”

 

Third, the letter states that SEC continues to provide waivers to the restrictions imposed on companies whose securities laws violations otherwise would have disqualified them from the “Well Known Seasoned Issuer” (WKSI) privileges. The letter states that the agency has granted 20 out of 28 requests for “bad actor” waivers. The letter also states that for the first time since 2005, the agency has granted waivers for companies guilty of criminal misconduct (citing to the waivers given UBS, Royal Bank of Scotland and Deutsche Bank after those banks Libor scandal-related admissions, and the waivers given to the five banks that recently made foreign currency exchange-related admissions). The letter questions whether these banks deserved to “continue to enjoy special privileges under the securities laws despite deep breaches of trust and evident mismanagement displayed in these cases.”

 

Fourth, the letter asserts that White has failed to address concerns related to White’s frequent need to recuse herself from matters before the Commission because of White’s prior law firm activities or because of White’s husband’s law firm’s involvement. The letter states that White had claimed during her confirmation hearings that potential recusals would lead to “minimal disruption.” White apparently has had to recuse herself from over four dozen enforcement investigations, the impact of which the letter asserts has been “quite damaging.” Among other things, her numerous recusals have meant all too frequent deadlocks at the commission level.

 

In addition to these four topics, the letter cites other concerns, including “the failure to address undisclosed campaign contributions,” and the fact that that the agency has “backed down” on Dodd-Frank rules requiring asset-backed securities disclosures.

 

Warren concludes her letter by saying that to White that she (Senator Warren) is “disappointed that you have not been the strong leader that many had hoped for – and that you promised to be.” She also asks that the agency provide additional detailed information responsive to six information requests identified at the end of the letter.

 

Even in the bizarre, grandstanding universe that political Washington inhabits, this letter is extraordinary. For starters, Warren is a Democratic senator and White was an appointment of the current Democratic president. In addition, the scolding tone would be aggressive in any kind of letter, but it is particularly noteworthy in a letter that was clearly intended to be public. The suggestion that Warren presumes she not only has the right to publicly criticize White but to tell the SEC chair what to do and how to do her job is also striking.

 

The outraged tone of the letter seems strangely disconnected from the fact that many of the unaddressed matters of which Warren complains are within the purview of the full Commission and not just of the Commission’s chair. For example, the criticisms about the failure to issue final pay ratio rules ignores the fact that the rules as initially proposed were highly controversial and were issued over strong dissents at the time. Whether or not the agency should have by now gotten the final Rules out, it would have been more realistic for the letter to have acknowledged that the controversies surrounding the Rules obviously have a lot to do with the delays.

 

The more interesting question  is what impact the Senator’s hectoring approach will have. It is pretty clear from the tone and the letter’s final demand for additional information that the Senator will continue to press White. Which begs the question – will the Senator’s badgering affect White’s (and the SEC’s) actions? For example, might the agency in response require more admissions of guilt, or more specific admissions of guilt?

 

In the end, the letter is a reminder of how tough it is to be in a prominent position in Washington. The fact that the SEC chair has to face this criticism from a politician within the same party as the President that nominated the chair shows just how tough it is getting to be there.

 

Those interested in some insight into Senator Warren and what makes her tick will want to read the May 6, 2015 profile of the Senator that appeared in The New Yorker. The profile can be found here.

beijing olympicsThe dramatic pre-dawn arrest in Zurich of nine FIFA officials on bribery-related charges dominated the headlines last week. The FIFA corruption investigation news last week also overshadowed the resolution of an FCPA enforcement action involving different sports-related events – BHP Billiton’s sponsorship-related activities at the 2008 Summer Olympics in Beijing. Though the SEC’s enforcement action against BHP Billiton represents a lower-magnitude development than the FIFA bribery scandal, the enforcement action and the $25 million civil monetary penalty to which the BHP Billiton agreed in order to resolve the matter has some extraordinary features and also has a number of important implications – some of which are quite troublesome, particularly in context of the ongoing FIFA scandal.

 

The SEC’s May 20, 2015 press release about the BHP Billiton enforcement action can be found here. The cease and desist order that the company entered can be found here. The company’s May 20, 2015 press release about the resolution of the SEC investigation can be found here.

 

Background

BHP Billiton is a global mining company with headquarters in Australia and the United Kingdom. The company’s American Depositary Shares trade on the New York Stock Exchange. The company was an official corporate sponsor of the 2008 Beijing Olympic Games. The company paid a sponsorship fee and supplied raw material for the sponsorship rights.

 

In connection with its sponsorship initiative, the company developed a sponsorship hospitality program under which the company invited over 650 people to participate. The purpose of the hospitality program was to “reinforce and develop relationships with key stakeholders” and to “help facilitate approvals for future projects.”

 

Among the invitees were 176 senior-level government officials, including 98 representatives of state-owned enterprises. The company also invited 102 spouses of these governmental officials. According to the SEC, the majority of the invitations to government officials were from countries in Africa and Asia that “had well-known histories of corruption.” The hospitality packages included luxury hotel accommodations, meals, event tickets and sightseeing excursions with a cost of between $12,000 and $16,000.  The company offered round-trip business class airfare to approximately 51 foreign government officials as well 35 of the officials’ spouses. Sixty government officials ultimately attended, 24 of them with their spouses or guests. A number of other officials accepted the invitation but ultimately cancelled before the Olympics began.

 

In connection with its planned hospitality program, the company identified the risk involved with inviting government officials and the potential for the program to violate anti-corruption laws. Accordingly, the company put in place a pre-invitation approval process to address the risk. The process required business unit managers to complete a hospitality program application that included on its cover sheet a short description of the company’s anti-bribery policies. However, while the company had controls in place with respect to the hospitality program, the SEC later said that the controls “did not adequately address the anti-bribery risks associated with offering expensive travel and entertainment packages to government officials.”

 

Specifically, the control weaknesses the SEC identified included the fact that  the company did not require independent legal or compliance review of hospitality applications by someone outside of the business unit submitting the application; that the company’s Olympic Sponsorship committee and ethics panel subcommittee did not review the appropriateness of individual hospitality applications; that some of the applications were not accurate or complete; that the company did not provide its employees and executives with any specific training; and that the company did not institute a process for updating the applications in order to reassess the appropriateness of the application in light of changed circumstances.

 

To illustrate the problems associated with the company’s application process, the SEC cited four examples of governmental officials who the company had invited to the Olympics.  The examples involved officials from Burundi, the Philippines, the Democratic Republic of Congo, and Guinea. According to the SEC, these four officials were directly involved in, or in a position to influence pending negotiations, regulatory actions or business dealings. Interestingly, although all four received hospitality invitations, in the end only one of the four, the Burundian official (and his wife) actually wound up attending the Olympics. The others cancelled or had their invitation withdrawn prior to the Olympics. Even more interestingly, the SEC did not contend that the invitation to these officials in fact improperly influenced the negotiations, regulatory actions or business dealings.

 

In the cease and desist order, the SEC averred that the company had violated two provisions of the FCPA, the provision requiring companies to keep accurate books and records and the provision requiring the company to devise and maintain an appropriate system of internal accounting controls. The company agreed to pay a civil monetary penalty of $25 million and to provide the SEC with voluntary reporting on its FCPA compliance for one year. The company neither admitted nor denied the wrongdoing the agency alleged.

 

Discussion

This SEC enforcement action and its resolution have a number of noteworthy features. First, the $25 million that the company agreed to pay represents, according to the FCPA Professor (here), the largest civil money penalty ever imposed by the SEC in an FCPA enforcement action. There have of course been many much larger settlements of FCPA enforcement actions, but the bulk of those other large settlements represent disgorgement amounts. This sizeable penalty is noteworthy in and of itself, but it is also noteworthy because the company was required to agree to pay this amount to extract itself from the enforcement action even though, according to the SEC itself, the company provided “significant cooperation” in the investigation and even though the company voluntarily undertook “significant remedial actions.”

 

But perhaps even the even more extraordinary thing about this record-setting fine is that it was imposed even though the SEC did not allege any violation of the FCPA’s anti-bribery provisions. The only violations the SEC alleged were books and records and accounting control violations. The problem with the hospitality program was not that it facilitated improper payments to government officials, but that, according to an SEC official’s statement quoted in the agency’s press release, the program “created a heightened risk of violating anti-corruption laws.” In other words, the mere fact that the program might have led to an improper payment was enough to subject the company to scrutiny and to oblige the company to pay a record-setting fine.

 

The other extraordinary thing about this investigation and the company’s obligation to pay a $25 million fine is that the company had anticipated that the program could create risks and had put a control process in place. The problem, therefore, was not that the company did not take steps to try to address the risk; rather, as an SEC official stated in the agency’s press release, the problem was that though the company “put some internal controls in place,” the company “failed to implement sufficient internal controls to address” the “heightened risk.”

 

Most people understand the FCPA to be an anti-bribery law, with the implication being that as long as the company doesn’t make any improper payments, it won’t have any FCPA problems. However, as this case shows, the reality is that FCPA authority –as interpreted by the SEC – reaches far beyond the payment of bribes. The Paul Weiss law firm, in its May 28, 2015 memo about the BHP Billiton enforcement action (here) noted that the case “represents a rare example of the SEC bringing internal accounting controls and books and records charges in a case where it neither alleges actual bribery of a foreign official, nor suggests that such bribery took place.”

 

 

As the Steptoe & Johnson law firm put it in their May 27, 2015 memo about the BHP Billiton enforcement action entitled “Does SEC’s Enforcement Action against BHP Billiton Take the FCPA’s Accounting Provisions Too Far?” (here), this case “represents one of the most aggressive uses by the SEC to date of its accounting, and in particular its internal controls, authorities in an FCPA context.”

 

 

Rather than an improper payment, the alleged FCPA violation apparently, according to the Paul Weiss law firm, is based “solely on SEC’s subjective assessment of the adequacy of an issuer’s anti-corruption compliance program.” In particular, the SEC’s books and records charge “appears to rest on highly specific criticisms of the internal forms used to evaluate individual hospitality applications.” The law firm commented in that regard that “there is nothing in the language of the books and records provision to suggest that it encompasses purely internal application forms completed for the purpose of approving gifts and entertainment expenditures.”

 

In light of the extraordinary reach the SEC asserted here, “many companies,” according to the Steptoe & Johnson memo, “will understandably be very uneasy about the direction of the SEC’s enforcement program.” This case suggests, according to the Paul Weiss law firm, that merely preventing improper payments alone is not enough to ward off SEC FCPA enforcement; rather, “unanticipated gaps or shortcomings in the implementation of a compliance program may become fodder  for an SEC investigation or enforcement action, even where there is no actual (or even alleged) bribery.”

 

Given what happened here, companies may have particular concerns about their organized corporate entertainment activities. Clearly, this enforcement action, according to the Steptoe law firm, “raises the question whether business entertainment for the purposes of relationship building – a necessary activity in most, if not all businesses – will raise enforcement risks when it nevertheless does not rise to the level of a specific, prohibited quid pro quo arrangement.” The Paul Weiss law firm’s memo suggests that the implication of these developments is that “companies that engage in organized business entertainment, gift-giving, marketing, sponsorships, or even community development projects would be well-advised to take a second look at their controls, processes, communication and training with respect to each of those activities.”

 

Indeed, reassessment of existing activities alone may not be sufficient. As a commentator noted in a May 24, 2015 column in the Sydney Morning Herald (here), multinational companies may now have to ask themselves “not just if they can handle the risks that are raised by major corporate sponsorships, but whether they have systems in place that are capable of detecting the risks in the first place.” The author suggests that not only will BHP Billiton now decide that “vacating the major-event field is the safest and best option,” but also that “ golden age of corporate sponsorships and networking is drawing to a close: corporate sponsorships might have to be a less important part of major-event business cases in coming years.”

 

The suggestion that major event corporate sponsorships, or at least the hospitality events associated with the sponsorships, might be a thing of the past is reinforced by the separate developments involved with the FIFA bribery scandal. The FIFA scandal has, at a minimum, raised serious questions relating to the organization’s relationship with its sponsors. Indeed, questions have even been raised about the banks that were involved with funneling the cash used for the improper payment.

 

For many years, corporate sponsorships have been a ubiquitous part of the global sports environment. In light of recent developments and the likely scrutiny that corporate sponsorships will now face, the involvement of corporate sponsorships in international sporting events has likely changed forever.

 

We can leave for another day the discussion of the appropriateness of the U.S. regulator exercising enforcement authority over a company with its headquarters in Australia and the United Kingdom, in connection with activities not in the U.S. but solely in the company’s home countries and in China and allegedly involving officials from countries in Africa and Asia –particularly where there is no allegation that improper payments took place or even that the companies books and records did not accurately reflect the company’s financial condition.

 

There is more that might be said  on this topic, but suffice it to say here that this is yet another kind of risk exposure that a non-U.S company takes on when it chooses to list its securities on a U.S. exchange. This is  one of the many issues a non-U.S. company has to consider when make a choice in the context of a global economy of whether or not to list securities on a U.S. exchange.

 

Finally, for D&O insurers underwriting U.S.-exposed non-U.S. companies, this is yet another risk consideration that must be taken into account.

masseyMost senior corporate executive have a general understanding of the importance to them of their corporate indemnification rights. As discussed here, a related but sometimes even more important corporate benefit is the right to advancement – that is, the right to have their defense fees paid on a contemporaneous basis while legal proceedings against them are pending, subject only to the individual director or officer’s undertaking to repay the amounts if it ultimately is determined that the individual is not entitled to indemnification.

 

As I have noted in prior posts (refer for example here), an issue that frequently recurs is question of when the company may withhold advancement. The question is particularly common when new management has come in and the prior management is facing ongoing litigation as a result of their action prior to leaving the company.

 

From the perspective of the Delaware judiciary, corporate attempts to withhold advancement arise all too often, apparently. Delaware Chancellor Andre Bouchard began May 28, 2015 opinion in a case involving former Massey Energy Company CEO Donald Blankenship by saying that the case involves an “all too common scenario” – that is “the termination of mandatory advancement to a former director and officer when trial is approaching and it is needed the most.” In his May 29, 2015 post on his Delaware Corporate and Commercial Litigation Blog (here) about the Blankenship case, Francis Pileggi characterizes Bouchard’s preface to his opinion as “an expression of exasperation,” as if to say, “Here we go again – another company trying to evade its advancement obligations.”

 

Blankenship had been seeking to have the fees he was incurring in defense of a criminal case pending against him, arising out of the April 5, 2010 disaster in Massey’s Upper Big Branch Mine in Montcoal, West Virginia, in which 29 miners were killed. (Further background regarding the Upper Big Branch disaster and the litigation that followed can be found here.) Blankenship was Massey’s CEO at the time. Blankenship retired as Massey’s CEO effective December 31, 2010. On June 1, 2011, Alpha Natural Resources completed a $7.1 billion acquisition of Massey. For several years, Alpha advanced Blankenship’s legal fees incurred in the numerous legal proceedings arising out of the Big Branch Mine disaster.

 

On November 13, 2014, the U.S. Attorney indicted Blankenship in connection with the Upper Big Branch Mine disaster. Among other things, the four count criminal indictment accused Blankenship of conspiracy to willfully violate mandatory mine safety and health standards, conspiracy to defraud the United States by concealing mine safety violations, and making false statements to the U.S. Securities and Exchange Commission, as well as securities fraud for making false public statements. The criminal matter is scheduled to go to trial on July 13, 2015.

 

In early 2015, shortly after the indictment, Alpha stopped advancing Blankenship’s legal fees, primarily in reliance on an undertaking Blankenship had signed in which he acknowledged that his indemnification and advancement rights were contingent upon certain representations and undertakings (the “undertaking”), including a representation that  Blankenship had “no reasonable cause to believe that his conduct was ever unlawful.” The decision to withhold advancement was based on a determination by an officer of Alpha that Blankenship had breached this representation. Blankenship initiated an action against Alpha in Delaware Chancery Court seeking advancement of his unpaid legal expenses. At the time of the April 8, 2015 trial in Chancery Court action, Blankenship’s unpaid legal bills totaled over $5.8 million.

 

In his May 28, 2015 opinion, Chancellor Bouchard concluded that the undertaking cannot reasonably be interpreted as Alpha had and that the company’s conclusion that Blankenship had breached the representation does not provide a valid basis for Alpha to terminate Blankenship’s advancement rights under Massey’s corporate charter. (Indeed, Bouchard concluded that a reasonable person would not have thought Blankenship’s advancement rights could be terminated.) Bouchard not only concluded that Blankenship was entitled to advancement of his legal fees incurred in the criminal action but also that he was entitled to recover the attorneys’ fees he incurred in enforcing his advancement rights.

 

In ruling in Blankenship’s favor, Bouchard noted that while he found the undertaking on which Alpha relied to be unambiguous, even if the undertaking were to be viewed as ambiguous, Delaware law “supports resolving ambiguity in favor of indemnification and advancement.” As Francis Pileggi noted in his blog post about the ruling, if a company is going to try to withhold advancement on the basis of conditions in an agreement, “the terms of that condition must be beyond unambiguous, because all doubts will be resolved in favor of the claimant.”

 

However, even if under Delaware law strongly favors advancement and indemnification, there is no iron clad rule that individual directors and officers are going to prevail when they seek advancement. (For examples of cases where a court, applying Canadian provincial law, determined that a company properly withheld advancement, refer here and here.) As these cases show – and the tone of exasperated weariness with which Bouchard commenced his opinion underscores – all too often companies will try to renege on their advancement obligations when disputes arise.

 

The reason for these advancement disputes is no mystery. By definition, an advancement question will only arise if there is a corporate dispute in the form of legal proceedings pending. Sometimes, as is the case here, the legal proceedings involve significant problems at the company, a factor that can only be exacerbated if, as was also the case here, there has also been a change in management since the time of the conduct that gave rise to the problems. In other words, advancement rights are often construed while a battle is raging. All too often, the hostilities include skirmishing between the corporate executives and the corporate entity.

 

The frequency with which these kinds of dispute arise is one of the most significant reason why well-advices corporate executives will not depend just on the indemnification and advancement provisions of the company charter or by-laws, but will in addition seek to have their rights memorialized in a separate, written indemnification and advancement agreement.

 

One very good reason that directors and officers will seek to put contractual indemnification agreements in place is so that if the individuals are the target of claims after they have left the company, they can claim their rights of indemnification notwithstanding the arrival of new management. The contractual indemnification provides them an extra measure of protection and some level of assurance that their rights will be protected if claims later arise. A separate written indemnification provision can not only provide much greater procedural specificity but it can also provide certain protections against wrongful withholding of indemnification, by providing presumptions in favor of indemnification and providing for “fees on fees” (that is, fees incurred in order to enforce rights to advancement or indemnification).

 

A May 26, 2015 post on the Mintz Levin law firm’s Securities Matters blog (here) details the importance for corporate officers of having a separate written indemnification agreement and discusses the key features that this type of agreement should include. As the blog post notes, written indemnification agreements have several advantages for corporate officers over the indemnification provisions of articles of incorporation or bylaws. Among other things, written agreements are “more easily enforced by D&Os because they are bilateral contracts reflecting bargained-for consideration in the form of an individual’s agreement to accept or continue service with the company.” Written agreements “typically provide broader and more thorough protection of D&O’s indemnity rights than statutes and organizational documents.”

 

As the blog post discusses, among other key provisions, a written agreement will include: definitions of key terms (such as “expenses” and “proceedings,” to ensure that the advancement and indemnification rights apply to the broadest possible range of costs and legal actions); procedures and time-frames for the provision of advancement and the resolution of any disputes that might arise; and the provision for fees-on-fees. In addition, “the indemnification agreement typically will require that the company provide D&O liability insurance that protects the indemnitee to the same extent as the most favorably insured of the company’s and its affiliates’ current D&Os,” to the extent commercially available.

 

In short, the use of a separate written agreement is one way to take steps while times are calm and relationships are cooperative to ensure that the individual directors and officers’ rights will be protected even when things are no longer time and relationships have turned combative.

 

Unfortunately, the most a written indemnification agreement can do is to try and ensure that the rights of directors and officers will be protected if disputes arise; an agreement alone can not prevent disputes from arising.

 

Because these kinds of disputes can and all to often do arise, it is important to keep in mind a critical component that should be a part of every public and sizeable private company’s D&O insurance program. A well-designed D&O insurance program will include within its overall structure a layer of so-called Side A/DIC insurance. These kinds of policies have a number of important features that are available to protect individual directors and officers in certain kinds of catastrophic claims.

 

Among the parts of many of these policies’ “difference in conditions” insurance  protection is a feature by which the Side A/DIC insurer will “drop down” and provide corporate executives first dollar protection if the corporate entity for any reason wrongfully withholds corporate advancement or indemnification. The idea of this insurance protection is that the individual should never be in a position where they cannot defend themselves because the company is withholding advancement. The insurer will step in and advance payment on the individual’s behalf and where appropriate seek to be reimbursed by company that wrongfully withheld advancement.

 

The critical importance of these and other features of a well-designed D&O insurance program underscores the importance for corporate insurance buyers and their executives to have a knowledgeable and experienced insurance broker involved in the corporate insurance acquisition process, so that these kinds of issues are identified and taking into account when the insurance program is put together. A knowledgeable and experience broker will understand how directors’ and officers’ advancement and indemnification rights operate and how the operation of these rights will and should interact with the company’s D&O insurance program.

 

One final note. I know that there will be those who might be outraged that Blankenship is having his defense fees advanced, given the magnitude of the mining disaster and the nature of the criminal allegations against him. However, as I noted in an earlier post in which I discussed BoA’s decision to advance the defense fees of former Countrywide CEO (and poster-child for the excesses that led to the financial crisis) Angelo Mozilo, “under Delaware law and under the legal understandings that BofA reached when it acquired Countrywide, BofA has a legal obligation to advance Mozilo’s expenses. The only outrage would be if BofA refused to do so.”

 

That’s the thing about advancement, the corporate obligation applies even when controversy arises — indeed, the moment when controversy arises often is precisely the moment when advancement is most needed. As I said at the time about the objections to advancing Mozilo’s defense expenses, “the objection about Mozilo’s defense expenses is not to advancement of defense expenses as a general matter, but to advancement for Mozilo in particular. There is no principled basis on which to isolate one individual, no matter how unpopular he may be, and single him out as the one person retroactively disentitled to his otherwise enforceable rights.” As with Mozilo, so too with Blankenship.

 

For a basic description of the the interaction between indemnification and D&O insurance, refer to my prior post here, which was the first installment in my “Nuts and Bolts of D&O Insurance” series. (The entire series can be found here.)

 

Special thanks to the several readers who send me copies of the Delaware Chancery Court’s opinion in the Blankenship case.

floridaIn a coverage dispute arising out of the long-running Rothstein Ponzi scheme scandal, a Southern District of Florida judge, applying Florida law, has held that the professional services exclusion in the Rothstein bank’s D&O insurance policy precluded coverage for claims brought against the bank and certain of its directors and officers by the Rothstein law firm’s bankruptcy trustee. As discussed below, the court’s decision raises questions about the appropriate wording for the professional services exclusion in a service company’s D&O insurance policy. The May 18, 2015 decision in the case can be found here.

 

Background

The Rothstein law firm bankruptcy trustee along with lead feeder fund’s bankruptcy trustee’s filed claims against Gibraltar Private Bank & Trust and certain of its directors and officers alleging that the defendants aided and abetted Rothstein in the perpetration of the Ponzi scheme fraud. The bank submitted the claims to its D&O insurers, which denied coverage for the claims in reliance on the professional services exclusion in the policies.

 

After the D&O insurers denied coverage, the bank and its directors and officers entered a series of settlements and related agreements  (what the court later referred to as “Coblenz agreements”) with the bankruptcy trustees and with the claimants in the underlying actions whereby the bank and the individuals consented to the entry of a judgment against them in exchange for an assignment of their rights under the D&O insurance policies and a agreement not to enforce the judgment against them except as to the insurance policy proceeds. The assignees then filed a coverage lawsuit in the Southern District of Florida against the D&O insurers. The insurers moved to dismiss.

 

The professional services exclusion provided that:

 

The insurer shall not be liable to make any payment for Loss in connection with any Claim made against any Insured alleging, arising out of, based upon, or attributable to the Organization’s or any Insured’s performance of or any failure to perform professional services for others, or any act(s), error(s) or omission(s) relating thereto.

 

The May 18 Opinion

In her May 18, 2015 opinion, Southern District of Florida Judge Kathleen M. Williams granted the defendant insurers’ motion to dismiss with prejudice, ruling that the D&O insurance policies’ professional services exclusion precluded coverage for the underlying claims. In concluding that the professional services exclusion precluded coverage, Judge Williams rejected several arguments that the plaintiffs had raised.

 

First, Judge Williams rejected the plaintiffs’ argument that the exclusion operated severally (that is, separately as to each insured person) rather than jointly. Judge Williams said that “a plain reading of the Professional Services Exclusion demonstrates that it bars coverage for any Claim made against any Insured arising out of any Insured’s failure to perform professional services for others.  The exclusion is not limited in its application to each Insured’s performance; instead it jointly bars coverage for all insureds for any Claim arising out of any insured’s performance or failure to perform professional service.” In reaching this conclusion, Judge Williams noted that the policies incorporated a so-called severability provision, which made certain of the policies’ exclusions (but not the professional services exclusion) severable, so that the conduct of one insured would not be applied to preclude coverage under the identified exclusions for other insureds.

 

Judge Williams also rejected the plaintiffs’ argument that because the exclusion did not define the term professional services, the exclusion is ambiguous and should be construed against the insurers. She reviewed several prior case decisions applying Florida law in which the courts had said that were a policy does not define the term “professional services,” the courts have considered whether the service at issue involves specialized skill, requires specialized training, is regulated, requires a degree, and/or whether there is an entity that provides certification or accreditation for individuals in the field. Judge Williams found that the provision of banking services represents the delivery of professional services within the meaning of the exclusion.

 

However, the plaintiff argued that the allegations against the bank and the individual directors and officers arose out of purely internal management and regulatory functions, not services to others. Judge Williams reviewed the allegations in the underlying complaint and concluded that the allegations in the complaint “arise out of, or are attributable to, the Insureds’ performance of or failure to perform professional services for other” – specifically banking services for the benefit of Rothstein and the Rothstein law firm accounts.

 

Finally, Judge Williams rejected the plaintiffs’ allegation that the application of the exclusion to preclude coverage for the delivery of banking services renders the coverage offered under the policy to be illusory, because every activity involved in the bank’s operations involves the delivery of banking services. In rejecting this argument, Judge Williams said that the D&O policies provide coverage for many claims that would not involve the delivery of services for others. She said, for example, the bank provides coverage for wrongful termination and harassment claims or for securities claims made against any insured.

 

Discussion

Within the constraints of the policy language at issue, Judge Williams’s decision on this coverage dispute arguably is unexceptional. (I don’t by that comment mean to suggest that I do not appreciate the work and effort that went into contesting the legal issues involved, which I understand were quite challenging and hotly contested; I am merely reflecting my opinion on Judge Williams’s ruling, not the degree of difficulty that the parties faced in this case.) However, for me, this decision raises more general question about the language used in professional services exclusions in service companies’ D&O insurance policies. I suggest below that the specific exclusionary language used in this policy is not appropriate for companies, such as banks, engaged in a service business.

 

By raising this language concern, I do not mean to suggest in any way that different language should have been used on this particular policy. I have no way of knowing whether or not the alternative, preferred language I identify below would have been available in connection with the placement of this policy. Indeed, the alternative language usually is not available, and the language used in this policy often is viewed as standard – which is the heart of the problem with the language, as far as I am concerned.

 

My objection to the language used in the professional services exclusion in the policy at issue in this case is based upon the purposes for which a professional services exclusion is included in a D&O insurance policy in the first place.

 

The purpose of a professional services exclusion in a D&O insurance policy is to align the various coverages in the policyholders’ liability insurance program, so that the D&O policy does not apply to claims that the policyholder’s E&O insurance policy. Because this is the purpose of the professional services exclusion, in my view the appropriate wording to be used in the exclusion is the “for” wording. I have always felt that the use of the broad “based upon, arising out of or in any way relating to” sweeps far too broadly for the exclusion’s purpose and threatens to extend the exclusion’s preclusive effect far beyond the exclusion’s purpose of keeping the various liability claims in the appropriate insurance lane.

 

But whatever the argument in general about the use of the broad “based upon or arising out of” language in a professional liability exclusion might be, I think the argument that the broad preamble sweeps too broadly is particularly compelling in the context of a business company in the services sector. I think there is merit to the plaintiff’s argument here that the way the broad preamble is interpreted and applied reaches into the very essence of the service company’s day-to-day operations. The plaintiffs’ argument that for a services business all likely claims will arise out of, relate to or in any way involve the company’s delivery of services is legitimate – and that is the reason why the professional services exclusion in a service business’s D&O insurance policy should have the “for” wording, not the “based upon or arising out of wording.”

 

The examples Judge Williams cites for the types of claims that are still covered under the policy notwithstanding the overbroad sweep of the exclusion to me unconvincing. The discrimination and harassment claims examples to which she referred are entirely inapposite. Those kinds of claims are employment practices liability claims not D&O insurance claims; the reference to those types of claims is entirely beside the point and proves nothing. Her reference to securities claims is closer to the mark but of less relevance to a private company; even if true, it leaves the entire remaining universe possible of D&O claims – that is, all of the various types of liability exposures for which a private company might buy D&O insurance – within the reach of the exclusion’s preclusive sweep.

 

Even if at the margins there are theoretical claims for which coverage might be preserved from the exclusion’s overbroad reach, that does not alter the fact that given the purposes for which the exclusion is in the policy, the exclusion should not – particularly for companies in services industries – be worded with the unnecessarily overbroad “based upon or arising out of wording.” Even though the narrower “for” wording  is not available in many instances even in a competitive marketplace, the “for” wording is the wording that should be used, given the purposes for which the exclusion is included in the policy in the first place.

 

In addition, Judge Williams analysis of the “jointly” but not “severally” interpretation of the policy exclusion suggest further to me that the severability clause contained in management liability insurance policies arguably should be extended to preserve coverage for claims against insured persons against whom claims are alleged that do not trigger the professional services exclusion. Even if allegations are made against one insured that triggers the exclusion, there is no reason why coverage should be excluded for other insured persons if the allegations against the other insureds are not “for” alleged wrongful acts allegedly committed in the delivery of professional services.

 

Special thanks to James Kaplan of the Kaplan Zeena law firm for sending me a copy of this opinion. Kaplan represented the primary D&O insurer in this case. I should hasten to add the views I have expressed in this blog post are, of course, entirely my own.

nystate1As I have noted in prior posts, “qui tam actions” under the False Claims Act often fit uncomfortably with typical D&O insurance policy terms and provisions. For example, the procedure whereby qui tam actions are filed but not immediately served raise questions of the claims made date (as discussed here), and with respect to the potential applicability of the prior and pending litigation exclusion (as discussed here).

 

In addition, as discussed in a recent case in the New York Supreme Court Appellate Division (First Department), a “qui tam action” pursued by the “relator” (a private third party claimant pursuing the False Claims Act claim individually) also raises questions about who the real party in interest is and how that could affect the availability of coverage under a D&O insurance policy.

 

In an April 30, 2015 decision (here), the New York intermediate appellate court held that even though the qui tam action claimant was pursuing the action individually, the government was the “real party in interest,” and therefore coverage for the action was precluded under the qui tam action defendant company’s D&O insurance policy’s regulatory exclusion.

 

As discussed below, this case presents yet another example of the problems that qui tam action under the False Claims Act can present for purposes of D&O insurance coverage. As discussed below, the question whether the exclusionary language at issue appropriately could be interpreted to preclude coverage for a qui tam action maintained by a relator is far from clear.

 

A May 19, 2015 post about the ruling can be found on the Wiley Rein law firm’s Executive Summary Blog, here.

 

Background

As discussed here, the federal False Claims Act imposes liability on those who defraud the government. The law also allows third-parties to bring qui tam actions in the form liability claims under the Act; if the qui tam actions are successful, the third-party can receive a portion of the recovery. When a third-party files a qui tam action, the Act requires that the complaint remain under seal for at least sixty days and that it “not be served on the defendant until the court so orders,” so that the government can decide whether it wants to intervene and pursue the action. Even if the government declines to intervene, “the person who initiated the action shall have the right to conduct the action.” The person who pursues this type of claim is referred to as the “relator.”

 

Huron Consulting Group (HCG) was named as a defendant in a qui tam action. The action alleged that HCG had violated the federal False Claim Act and the New York False Claims Act in connection with excessive Medicare and Medicaid billing. The government declined to participate in the action; the relator continued to pursue the action individually.

 

BCG sought coverage under its D&O insurance policy for the defense expenses it incurred in defending the claim. The D&O insurer denied coverage based on the applicable policy’s Regulatory Exclusion. The Regulatory Exclusion provides in pertinent part that there is no coverage for Loss in connection with claims “brought by . . . any federal [or] state . . . governmental entity, in such entity’s regulatory or official capacity.” The insurer filed an action in New York state court seeking a judicial declaration that the exclusion precluded coverage.

 

The trial court denied the insurer’s motion for summary judgment and granted BCG’s cross motion for summary judgment that the insurer was obligated to pay BCG’s defense costs. The insurer appealed.

 

The April 30 Opinion 

In an April 30, 2015 per curiam opinion, a unanimous five-judge panel of the New York Supreme Court Appellate Division reversed the lower court, ruling instead that coverage for the relator’s qui tam action was precluded by the policy’s regulatory exclusion.

 

In reaching its decision, the appellate court said that the trial court had erred in concluding that “the underlying qui tam lawsuit was brought by a private party, not a governmental entity operating in an official or regulatory capacity.” Rather, the appellate court said that while relators indisputably have a stake in the outcome of False Claims Act qui tam cases that they initiate, the Government remains the “real party in interest” in any such action.

 

The appellate court quoted a prior Second Circuit decision in which the federal appellate court said with respect to qui tam actions, even qui tam actions pursued and maintained by a relator rather than by the government, that “It is the government that has been injured by the presentation of such claims; it is in the government’s name that the action must be brought; it is the government’s injury that provides the measure for the damages that are to be trebled; and it is the government that must receive the lion’s share-at least 70%-of any recovery.” Because the U.S. government is the real party in interest, the regulatory exclusion applies to preclude coverage under the policy for the qui tam action.

 

Discussion

As I noted at the outset, and as I have noted in prior posts, qui tam actions fit awkwardly within the terms and conditions found in the typical D&O insurance policy. But while that awkward fit is a recurring problem, the outcome of this case goes beyond the standard awkwardness for these types of claims. The contention that the Regulatory Exclusion precludes coverage here is not self-evident, and a good case could made that the exclusion does not and was not intended to preclude coverage for this type of claim.

 

The exclusion precludes coverage only for claims brought “by” a governmental entity. Under the standard procedures for qui tam actions, the government had the opportunity to decide whether it would participate in the action. If the government had decided to intervene, then the action obviously would have been brought “by” the government. But the government chose not to intervene, and to me that clearly makes a different with respect to the question whether the action the relator continued and maintained was “by” the government.

 

It may well be that in a qui tam action maintained by a relator that the government is the real party in interest. That is, the qui tam action is clearly brought “on behalf of” the government. But the regulatory exclusion doesn’t preclude coverage for claims brought “on behalf of” the government; it only precludes coverage for claims brought “by” the government. The significance of the absence of the “on behalf of” language is underscored  by the fact that other standard D&O exclusions and policy provisions typically refer to actions brought “by or on behalf of” a specified party. The standard policy language used in these other provisions show that when an insurer intends to preclude coverage for claims brought “by or on behalf of” someone, there is language at hand for the insurer to use to do so. The insurer did not use this language in this regulatory exclusion, and that is an important – and to my mind, dispositive – difference.

 

If the insurer omits to include exclusionary language precluding coverage for claims “by or on behalf of” someone,  but instead uses only exclusionary language precluding coverage only for claims brought “by” someone, then the only way the exclusion can or should apply is if the claim was in fact brought “by” the identified person (in this case, a governmental entity). The exclusion should not apply if the action was brought and is maintained by a third party relator,  even if the government is the real party in interest, because even if the relator’s claim is indisputably “on behalf of” the government, the relator’s claim just as indisputably is not “by” the government.

 

If the carrier really does intend to preclude coverage for these types of claims, it should have to either expressly exclude coverage for qui tam actions maintained by relators or specify that its exclusion precludes coverage not only for actions brought “by” the government, but actions brought “on behalf of” the government. In the absence of these kinds of provisions, the policy exclusion should not apply to and there should be coverage under the policy for the relator’s qui tam action.

 

UPDATE: An informed source advises that the exclusion at issue in fact included the “on behalf of” language, which for some reason the court did not seem to think was important. It certainly changes my view of the outcome of this case, although the Court’s analysis standing alone still leaves me cold. 

 

If there is any good news here, it is that it is relatively rare for D&O insurance policies to include a regulatory exclusion of the type involved here. Typically regulatory exclusions are only found in D&O insurance policies of commercial banking institutions and some other types of financial institutions. Indeed, even for commercial banks’ D&O insurance policies, the inclusion of a regulatory exclusion is relatively unusual except for financial troubled institutions. In my view, coverage for a qui tam action maintained by a relator should not be precluded by a regulatory exclusion unless the exclusionary language expressly precludes those types of claims or the exclusion specifically states that coverage is precluded for claims brought “by or on behalf of the government.” Coverage should not be precluded for qui tam actions maintained by a relator where the regulatory exclusion precludes coverage only for claims brought “by” a governmental entity.