dcOn May 15, 2014, in an interesting decision illustrating how complex insurance contract wordings can interact to produce outcomes policyholders may not have expected or intended, District of Columbia Superior Court Judge Frederick H. Weisberg held that as worded a broad professional services exclusion in The Carlyle Group’s management liability insurance policy precluded coverage for defense costs incurred in defending against securities law and mismanagement claims filed in the wake of the credit crisis-related collapse of Carlyle’s affiliate, Carlyle Capital Corporation (“CCC”).  

 

In a ruling that practitioners in this area will want to consider carefully, the Court held that what seems to have been intended as an exclusion for E&O type claims against CCC precludes coverage for what were essentially D&O type claims filed against the various Carlyle entities. A copy of the court’s May 15, 2014 opinion can be found here.  

 

Background 

The Carlyle Group is the trade name of a global private equity firm. In 2006, Carlyle organized CCC, a Guernsey Island affiliate, to invest in residential mortgage backed securities (MBS). Carlyle Investment Management LLC (CIM) served as CCC’s investment manager pursuant to an investment Management Agreement (IMA). First in a private placement and later in a public offering, CCC shares were sold to investors. In 2008, the RMBS market collapsed and CCC slid into bankruptcy. 

 

As discussed here, numerous investors as well as CCC’s liquidators in bankruptcy filed lawsuits against the Carlyle entities and their respective directors and officers alleging various forms of misrepresentation and mismanagement. Carlyle notified their professional liability insurers of these lawsuits, seeking payment of their costs of defense. Carlyle’s insurers denied coverage for the claims. Carlyle then filed an action in the District of Columbia Superior Court seeking a judicial declaration that that defense costs were covered under the policies.  

 

The insurance company defendants moved to dismiss the Carlyle entities’ declaratory judgment action, arguing that all of the claims in the underlying litigation were precluded from coverage by an exclusion stating that the insurer is “not liable to make any payment for Loss in connection with any Professional Services Claim arising from Professional Services provided to Carlyle Capital Group.” The words “Professional Services Claim” and “Professional Services” are boldfaced in this exclusion. 

 

The policy defines the term “Professional Services Claim” as “a Claim made against any Insured arising out of, based upon, or attributable to Professional Services provided by an Insured.” The words “Professional Services” are bold-faced in this definition. 

 

The policy has a detailed definition of the term “Professional Services,” Which provides in pertinent part that the terms shall mean: 

 

(1) the giving of financial, economic or investment advice regarding investments in any debt, equity or convertible securities, collateralized debt obligations, collateralized loan obligations, collateralized bond obligations, collateralized mortgage obligations, asset-backed securities, limited partnership, limited liability company, private placement, entity, mutual fund, exchange traded fund, hedge fund, private equity fund, fund of funds, asset, liability, debt, bond, note, real property, personal property, commodity, currency, futures contract, index futures contract, option, option on a futures contract, warrant, swap, credit default swap, contract for differences (CFD), currency contract or other derivative instrument or contract, or any combination of any of the foregoing, including without limitation the giving of financial advice to or on behalf of any Fund (or any prospective Fund) or any separately managed account or separate account holder or any limited partner of any Fund (or prospective Fund) or any other investor or client of, in or with an Organization;

(2) the rendering of or failure to render investment management services, including without limitation investment management services concerning any of the foregoing investments, and including without limitation, the rendering of or failure to render investment management services to or on behalf of any Fund (or any prospective Fund) or any separately managed account or separate account holder or any limited partner of any Fund (or prospective Fund) or the rendering or failure to render investment management services to or on behalf of any other investor with an or client of, in or Organization;

(3) the organization or formation of, the purchase or sale or offer or solicitation for the purchase or sale of any interest(s) in, the calling of committed capital to, a Fund or prospective Fund; 

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(5) the providing of advisory, consulting, management, monitoring, administrative, investment, financial or legal advice or other services for, or the rendering of any advice to, or with respect to, an Organization, a Fund (or any of its limited partners or members) or a Portfolio Entity (or a prospective Organization, Investment Fund or Portfolio Entity); … or  

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(8) other similar or related services.

 

In opposing the insurers’ motion to dismiss, the Carlyle entities argued that the exclusion on which the insurers sought to rely was intended to exclude only claims arising from the delivery of professional services – that is, what is referred to in the insurance industry as “E&O claims” – not management liability claims such as those alleging acts errors or omissions in corporate governance, or what are referred to in the industry as “D&O Claims.” The Carlyle entities argued that because the underlying claims for securities violations and mismanagement were in the nature of D&O claims and not E&O claims, the exclusion on which the insurers sought to rely should not operate to preclude coverage. 

 

The May 15 Opinion  

In his May 15 opinion, Judge Weisberg granted the defendants’ motion to dismiss and dismissed the plaintiffs’ declaratory judgment action with prejudice. 

 

Judge Weisberg said with respect to the defined terms used in the policy such as Professional Services and Professional Services Claims, “whether or not the words mean something else in the insurance industry outside the context of this particular contract, those terms are specifically defined in the contract, the definitions are broad and unambiguous and, as used in the Exclusion, they operate to exclude coverage for all of the losses (and defense costs) at issue in this case.” 

 

Carlyle had argued that virtually all of the claims asserted in the various underlying lawsuits alleged misrepresentations or omissions with respect to the securities issued by CCC or with respect to the RMBS underlying the securities, or alleged mismanagement of the RMBS investments, and therefore that the claims  represented management liability claims that were not excluded by the terms of the Professional Services provisions of the exclusion on which the insurers sought to rely. 

 

However, Judge Weisberg found that the phrases used in the exclusion were defined in the contract “broadly enough to include virtually all of the conduct alleged” against the Carlyle entities in the underlying lawsuits, “whether or not such conduct would be characterized as professional services or corporate management in the industry generally or in some other insurance contract.” The question, Judge Weisberg said, is not whether the Carlyle entitles “thought those terms did not mean the same thing in the Exclusion as they meant in the coverage sections of the contract; by using defined terms in bold letters in the Exclusion, those terms can have only one meaning, and that is the meaning that the contract assigns to them.”   

 

It is important to note in this regard that Judge Weisberg applied the so-called “eight corners rule,” which considers only what it within the four corners of the policy and the four corners of the complaint. Under this rule, considerations outside of the four corners of the policy and of the complaint are irrelevant, including here consideration of arguments based on what the contract was intended to mean.

 

Judge Weisberg also expressly rejected what he described as the Carlyle entities’ invitation “to get down in the weeds to see if there may be some clever parsing of the language in any count in the many multiple-count complaints against them that could take that count outside of what would otherwise be the unambiguous language of the Exclusion.” He said in reviewing the various allegations that “each claim of each complaint arises from the provision of Professional Services to CCC.” He added that “to the extent that these claims – or some of them – would be classified as ‘management liability claims’ in the insurance industry generally or in some other insurance contract, in this contract they are Professional Services Claims arising Professional Services to CCC,” and therefore are precluded from coverage under the exclusion on which the insurers relied. 

 

Discussion 

I have some comments on this case, but I want to emphasize at the outset that I do not mean to criticize anyone or second-guess any decisions or actions that were made in the structuring or placing of this policy. I do not know what may have led to the inclusion of or wording of particular terms in this policy. Nothing I say here should be interpreted to suggest that I am finding fault in any way with this policy or the wordings in this policy. 

 

I will say that I can understand the Carlyle entities’ position here. When I read the exclusion at issue in this case, I interpreted the exclusion as directed toward E&O claims arising from the delivery of professional services to CCC. My interpretation would be that the exclusion was intended to preclude coverage for E&O claims arising from CIM’s delivery of professional services to CCC under the IMA.  

 

At the same time, while I feel comfortable with that interpretation of the intent of the exclusion, I can certainly understand the insurers’ position that regardless of what may or may not have been intended, the exclusion as written has a meaning based on its use of defined terms in the policy. And in that respect the policy’s broad definition of Professional Services appears sufficiently expansive to encompass the allegations in the underlying complaints. Judge Weisberg’s application of the “eight corners rule” prcluded consideration of matter outside the policy and the complaint in the interpretation of the policy.

 

Judge Weisberg’s determination that the exclusion precludes coverage is best understood by his comments in footnote 6, in which he notes that based upon the policy’s definition of Professional Services both the policy’s coverage section and the exclusion include “the rendering or the failure to render investment management services,”  “the providing of advisory, consulting, management, monitoring, administrative, investment, financial or legal advise to, or with respect to, and Organization or Fund,” “the organization or formation or, the purchase or sale or offer or solicitation for the purchase or sale of any interest(s) in, the calling of committed capital to, a Fund or prospective Fune,” and other or related services.” The exclusion, Judge Weisberg note, applies only when those activities related to CCC.

 

Judge Weisberg concluded that whether the allegation involved alleged false marketing of the CC shares; alleged failure to make required disclosures to purchasers of the CCC shares; alleged mismanagement of CCC under the IMA; alleged failure to take appropraite actions to mainatin liquidity when the RMBS market collpased; the operation of CCC with divided loyalties, the allegations fell within the Policy’s broad definition of Professional Services.

 

The irony here it was in Carlyle’s interests to have the broadest possible definition of Professional Services. Carlyle is a private equity firm. Insurance for organizations of this kind frequently include within a single policy or a single program of insurance both E&O coverage and D&O coverage. In order to secure the broadest possible coverage under the E&O insurance provisions in the policy, it was desirable for the term Professional Services to be defined as broadly as possible. However, the breadth of the term’s definition ensured that the exclusion on which the insurers relied here swept broadly in its preclusive effect for claims implicating the exclusion on which the insurers relied. 

 

This decision represents only a trial court’s interpretation. Carlyle Group has the option of seeking to appeal Judge Weisberg’s ruling to the Court of Appeals of the District of Columbia. It remains to be seen how this case might unfold in the event of an appeal. 

 

Nevertheless, this outcome in the Superior Court of this coverage dispute represents something of a cautionary tale, and a reminder that it is not always the case that the broadest possible policy terms and conditions will always operate to produce coverage outcomes in the insureds’ favor. This claim is also a reminder that professional liability insurance policies are complex and multifaceted, and a great deal of care must be taken to ensure that all of the policy provisions interact as intended to ensure that the policy operates as intended. Again, as I have stressed, I do not mean to second-guess or criticize anyone with respect to the policy at issue in this case. I am expressing no opinions about the way this policy was worded or structured.  

 

creitIn a recent post, I noted the Delaware Supreme Court’s ruling upholding the validity of  bylaw  provisions shifting the costs of litigation to an unsuccessful intra-corporate litigation claimant, which is the latest in a series of judicial decisions in which courts have recognized the authority of corporate boards to address shareholder litigation concerns in their bylaws. As noted here, in 2013 the Delaware Chancery Court in a case involving Chevron and Federal Express upheld the validity of forum selection clauses in corporate bylaws.

 

Along with these Delaware decisions involving corporate bylaw provisions addressing shareholder claims, in 2013, a Maryland trial court ruled that a provision in Commonwealth REIT’s bylaws requiring shareholder disputes and claims to be resolved through binding arbitration is enforceable, as discussed here.  Among other things, the Maryland court found that the sophisticated investors involved had assented to the provision because of a legend in the company’s stock certificates referring to the REIT’s bylaws. As interesting as this decision was, it was only a single trial court decision, and therefore arguably of limited value.

 

However, the enforceability of the Commonwealth REIT bylaw provision requiring shareholder claims has now been upheld by two other courts. As discussed in a May 15, 2014 Law 360 article by Andrew Stern, Alex Kaplan and Jon Muenz of the Sidley Austin law firm entitled “2 More Bullets to Fight Corporate Activism” (here, subscription required), these two courts have “elaborated upon and further supported the initial 2013 trial court decision enforcing the arbitration provision in Commonwealth REIT’s bylaws.”

 

According to article, the first of these two recent decisions was issued in February 2014 by the Maryland Circuit Court in Baltimore County, the same court that had issued the earlier decision. The more recent decision involved a separate shareholder derivative lawsuit against Commonwealth REIT, but unlike the earlier lawsuit which had involved “sophisticated shareholder,” the more recent derivative claim involved self-described “ordinary shareholders.”  These “ordinary shareholder” argued that they could not be held to have assented to the arbitration provisions or to the unilateral ability of the board to amend the bylaws at the time they purchased their shares.

 

In rejecting the “ordinary shareholders” arguments, the Maryland court relied in part on the Delaware Chancery Court opinion in the Chevron case in which the Chancery court upheld the validity of the forum selection clause. In particular, the Maryland court referenced the Chancery court’s ruling that corporate bylaws are part of a “flexible” contract that may be amended unilaterally by corporate boards. As the law firm article puts it, “guided by the Delaware opinion, the Maryland court found that Maryland law provided the trustees of REIT’s with similar unilateral powers of which investors have adequate notice.”

 

Accordingly, the Maryland court held that the REIT’s shareholders assent to a contractual framework that “explicitly recognizes that they will be bound by bylaws adopted unilaterally,” and that they purchased their shares with constructive knowledge that the arbitration bylaws were in effect, which was enough to constitute mutual assent.

 

The Maryland court also rejected the argument, of the type the U.S. Supreme Court provision had rejected in its 2013 decision American Express v. Italian Colors Restaurant (for more information about which refer here) that the arbitration provision would make the pursuit of derivative actions prohibitively expensive. (The derivative claimants argued that in arbitration, unlike in a derivative lawsuit, they may not be able to seek or obtain reimbursement of their attorneys’ fees, as they might in a lawsuit.) In reliance on the American Express decision, the Maryland court said that the fact that it is not worth the expense involved in pursuing a remedy does not constitute the elimination of the right to pursue the remedy.

 

The second of the two recent cases that the law firm memo discusses also involves the interpretation of Commonwealth REIT’s arbitration provisions, but related to a shareholders derivative action that had been filed against the REIT’s trustees in the District of Massachusetts. As discussed in her March 26, 2014 opinion (here), Judge Denise Casper found that in light of the prior Maryland decisions she was precluded from ruling on the enforceability of the REIT’s arbitration provisions under the principles of res judicata. However, she went on to say that if she were not precluded, she too would have found REIT’s bylaw arbitration provision to be enforceable.

 

Applying Maryland law, Judge Casper held that “constructive knowledge, constructive notice, and knowledge/notice through incorporate-by-reference are adequate to inform and bind a party to a contract.” As the law firm memo discusses, Judge Casper found the legend on the stock certificates sufficient to bind the shareholders to the arbitration provision. She also rejected the argument that requiring derivative plaintiffs to arbitrate would render the prosecution of derivative actions cost-prohibitive.

 

Discussion 

Although the decisions discussed above recognizing the enforceability of arbitration provisions in corporate bylaws involve only a single company, the fact is that mulitple courts have now recognized the enforceability of arbitration provisions in Commonwealth REIT’s corporate bylaws. Certainly none of the courts have been persuaded to reject the possibility of a bylaw arbitration provision out of hand, and indeed none has been persuaded that such a provision should not be unenforceable. This does not mean, of course, that other courts might not be persuaded to reject or to decline to enforce an arbitration provision but it does suggest that these kinds of provisions may withstand challenge and scrutiny.

 

These cases involving Commonwealth REIT’s bylaw arbitration provision, along with the recent Delaware courts upholding the authority of corporate boards to amend their bylaws to address the way in which and the conditions under which shareholders may pursue intra-corporate claims represent a nascent but nonetheless potentially significant trend in the shareholder litigation environment. At least so far, courts have seemed receptive to the authority of corporate boards to adopt these kinds of provisions, which undoubtedly will encourage other boards to adopt similar provisions.

 

Moreover, it seems that though this trend still at this point is merely nascent, the courts have already started building off the earlier decisions on these issues. Significantly, the Maryland court looked to and relied upon the Delaware Chancery court’s decision in the Chevron case in considering the powers of boards to unilaterally adopt provisions addressing intra-corporate litigation, showing that the limited but building case law in this area could support other decisions on related issues and in other courts.

 

The Delaware Supreme Court’s recent decision upholding the validity of a fee-shifting by law has the potential to change the economics of shareholder litigation. However, the possibility that corporate boards might be able to adopt shareholder provisions requiring shareholder claims and disputes to be arbitrated could even more dramatically change the shareholder litigation landscape.

 

The possibilities in this regard would be further magnified if the bylaw arbitration provision were to expressly incorporate a class action waiver of the type the U.S. Supreme Court upheld in the American Express case. Of course, as I noted here, there is nothing that says that merely because the Supreme Court has recognized the enforceability of class action waivers in commercial and consumer agreements means that courts will enforce class action waivers in corporate bylaws. But I suspect it will only be a matter of time before we see a case involving class action waiver provision in corporate by laws 

 

Given the U.S. Supreme Court’s willingness to enforce arbitration provisions in commercial and corporate contracts, more companies could decide to adopt bylaw arbitration provisions.  At a minimum, I think we will see further activity in the courts addressing these kinds of provisions. On a more general level, I think we can expect to see further experimentation from corporate boards as they seek to address shareholder litigation in their corporate bylaws.

 

It does seem as if all of a sudden we are in a period where corporate boards are increasingly willing to try to use their corporate bylaws to try to shape the rules surrounding intra-corporate litigation, and at least so far courts have been receptive to the boards’ experimentation. It remains to be seen how far courts are willing to go with these experiments but at this point it does seem as if there is at least the potential that corporate bylaw revisions could significantly alter the shareholder litigation landscape.

 

Special thanks to Alex Kaplan of the Sidley Austin law firm for sending me a link to his and his colleagues’ article about the development involving the Commonwealth REIT arbitration provision.

hongkongOn May 27, 2014, the Professional Liability Underwriting Society (PLUS) will host its 2014 Professional Liability Regional Symposium in Hong Kong. This half-day program will focus on regulatory and corporate fraud issues facing the Asian marketplace. PLUS’s presentation of this event marks the third year that PLUS has hosted a regional educational and networking event in Hong Kong.

 

The event will be held from 2:00 pm to 6:00 pm on Tuesday May 27, 2014 at the Hong Kong Football Club. The event will be followed by a networking reception. The event program includes several distinguished speakers and panelist. The keynote speakers include Mark Robert Steward, who is a member of Hong Kong’s Securities and Futures Commission and Executive Director with responsibility for the Enforcement Division. The keynote speakers will also include Kenneth Morrison of Mazars CPA Limited and Richard Hancock of NYA International Limited. A full listing of the event speakers and panelists can be found here.

 

This annual event has attracted insurance industry professionals, attorneys and many others in the past and the event promises to be well-attended again this year. Industry professionals in Hong Kong and elsewhere throughout the region will not want to miss this important educational and networking event. I strongly urge everyone to join their industry colleagues and to help support PLUS’s efforts to help develop the professional liability community in Hong Kong. Space is limited so registration now is well-advised. To register or for further information, please refer here.

labergereThe recent discovery in the Munich apartment of Cornelius Gurlitt of a massive trove of Nazi-looted art has drawn renewed attention to the fraught and murky world of art provenance – that is, the ownership history of art works, which can be critical for determining who holds proper title to the art. Provenance questions frequently lead to legal disputes and these disputes can take many forms – including, recently, a D&O claim against the President of University of Oklahoma, among others.

 

In May 2013, Lèone Meyer, a descendant of one of the founders of the Galleries Lafayette department store and the sole heir of her father, Raoul Meyer, filed a lawsuit in the Southern District of New York seeking to recover from the Fred Jones Museum at the University of Oklahoma in Norman, Oklahoma a painting by the French Impressionist painter Camille Pissarro. The painting, pictured above, entitled Bergère rentrant des moutons (Shepherdess Bringing in Sheep), often referred to as La Bergère, was donated to the museum as part of a large 2000 bequest by University benefactors. Background regarding the painting can be found on the Museum’s website, here.

 

Meyer claims the painting had been taken from her father’s art collection during the Nazi occupation of France in World War II and that it entered the U.S in the mid-1950s where it was sold to the benefactors by a New York art gallery.

 

Meyer’s amended complaint, which can be found here, names as defendants the Board of Regents of the University of Oklahoma; David Boren, the University’s President, who is named in both his individual capacity and his capacity as President of the University; the University of Oklahoma Foundation; several New York art galleries and related entities; and the American Alliance of Museums and the Association of Art Museum Directors.

 

The complaint, which seeks the return of the painting, alleges substantive claims for conversion; replevin; constructive trust; declaratory relief; restitution base on unjust enrichment; and two counts of breach of contract against third-party beneficiary (relating to museum and international provenance guidelines and requirements).  Background regarding the lawsuit can be found here.

 

With respect to the Board of Regents, the complaint names the Board as such. The individual members of the Board, although not named as individuals defendants, are identified by name in the complaint. The complaint alleges that the Board is a proper defendant because it has the “authority to everything, not expressly prohibited, necessary to accomplish the objectives of the school.”

 

With respect to Boren, the University President, the complaint alleges that he is responsible for “the management, control and direction” of all University entities, including the Museum. The complaint further alleges that the University’s decision to accept the gift of the painting “was authorized or ratified by Boren.” The complaint alleges further that “prior to acceptance of La Bergère, Boren and the University failed to undertake any reasonable effort to investigate proper title or provenance of La Bergère, although knowledge of La Bergere’s disputed titled and provenance was readily available using only minimal diligence.” The complaint alleges that Boren “has deprived Plaintiff of a property interest in La Bergere, first by accepting the painting without investigating proper title and provenance, and, second, by the continued possession [of the painting by the Oklahoma Foundation].”

 

Although Boren was initially named as a defendant in both his individual and his official capacity, the parties to the lawsuit stipulated to the dismissal of Boren in his individual capacity.

 

The defendants have moved to dismiss the plaintiff’s complaint. As reflected in the memorandum in support of their dismissal motion (here), the various Oklahoma defendants argue that the Southern District of New York lacks personal jurisdiction over them as they had insufficient contacts with the forum for the court to exercise jurisdiction. The Board of Regents and Boren also assert that the Court lacks subject matter jurisdiction, as they are agents of the state of Oklahoma and therefore are afforded immunity from suit in federal court under the Eleventh Amendment.

 

The defendants also assert that the plaintiff’s claims are barred by the statute of limitations and the doctrine of laches. In particular, the defendant assert that in 1953 Raoul Meyer, the plaintiff’s father, had filed a legal action in Switzerland to obtain possession of the painting, where his claims were rejected (apparently on statute of limitations ground). The defendants allege that the ruling of the Swiss court is preclusive of the plaintiff’s claims under the doctrine of res judicata and principles of international comity.  Finally, the defendants argue that New York is not an appropriate forum as almost none of the critical acts alleged took place in New York.

 

The motion to dismiss remains pending before Southern District of New York Judge Colleen McMahon.  However, in a May 13, 2014 handwritten note on a letter sent from the plaintiff’s counsel, Judge McMahon indicated that she is about to rule on the dismissal motion, expressly noting that recent Supreme Court case law “deprives the Court of jurisdiction over the OK defendants.” (Presumably she is referring to the U.S. Supreme Court’s February 2014 decision in Walden v Fiore, addressing the question of when the court in a forum state may exercise jurisdiction over a defendant from another state where all of the wrongful conduct alleged against the defendant took place outside the forum state.)

 

Even if Judge McMahon were to dismiss the Oklahoma defendants from the lawsuit on the grounds of lack of personal jurisdiction, the plaintiffs could try to refile the lawsuit in Oklahoma – subject of course to all of the other defenses on which the defendants seek to rely. But in addition to the lawsuit itself, the Oklahoma defendants are also under pressure from an entirely different direction. According to news reports (refer for example here), state legislators in Oklahoma are now calling for the Museum to return the painting to the plaintiff.  Four legislators apparently have introduced a resolution calling for the University to restore the painting to the plaintiff.

 

How all of this ultimately will turn out remains to be seen. The plaintiff’s amended complaint itself is absolutely fascinating, and I recommend it to anyone interested in an intricate tale that interweaves history and the rarified world of fine art.

 

While this dispute is of interest in and of itself, I mention it here and commend it to the attention of this blog’s readers as an example of the way that an art provenance dispute can lead to D&O claims. Unfortunately, provenance disputes are not uncommon, and when they arise, they can involve claims against the senior management and board of the entity or organization holding the disputed art work, in the same way that the claims were asserted here against the Board of Regents and against Boren.

 

How the entity’s management liability insurance policy will respond depends on a number of factors, including in particular the specific terms and conditions of the policy involved. Of particular concern is that the some carrier’s management liability insurance policies for museums contain an exclusion that could preclude coverage for loss arising from disputes over the title or provenance of art works. Others will offer defense cost only protection for provenance and title disputes subject to a restricted sublimit.

 

An additional potentially troublesome factor here from an insurance standpoint is that Boren was named as a defendant in both his individual and his official capacity. Presumably, the University’s management liability insurance policy would protect him in his official capacity, but not in his individual capacity. Fortunately, this potentially complicating issue was eliminated when the parties stipulated to the dismissal from the lawsuit of Boren in his individual capacity.

 

If nothing else, this case shows the problems that museums and others may face when the acquire art works about which ownership issues later arise. These disputes can be very costly to defend. Even if the collector is able to defeat the claim based, for example, on a technical defense, the collector may find its ability to sell the art work to be encumbered. As discussed here, the art world is becoming receptive to the purchase of title insurance as a way to protect those acquiring art from these kinds of disputes. Although obviously of interest to individual art collectors, the purchase of title insurance in connecion with the acquisition of an art work also could be particularly important for museums and other entities in light of the exclusion frequently found in D&O policies precluding (or severely limiting) coverage for disputes over title or provenance of art works.

 

Many thanks to a loyal reader for sending me a copy of the Amended Complaint from the dispute over La Bergère.

 

We May Have to Amend the Definition of Insured Person: According to a news report (here),  Hong Kong based venture capital firm Deep Knowledge Ventures (DKV) has appointed a machine learning program to its board. According to the report, the softiware is expected to have an equal vote in the firm’s investment decisions. (Special thanks to a loyal reader for a link to the news article.)

 

Today’s Grammar Question: In the title to today’s blog post, should I have omitted the comma after Provenance and before the word “and”? The use of the so-called serial comma is a matter of some dispute. As discussed here, writers using a journalistic style will omit the comma, while those using an academic style will include the comma. A review of other sources convinced me to keep the comma before the word “and” in the title. I figured I would go with it and see if anyone commented — or even noticed.  

 

sharbaughIn a recent post, I noted the concerns that are developing as the various provisions of the JOBS Act are staged in. These concerns are sufficiently significant that only two years after Congress passed the JOBS Act, there are proposals circulating in Congress to revise some of the JOBS Act’s provisions. Among the areas where concerns have emerged is the Act’s provisions relating to “crowdfunding.”  

 

As concerns have arisen about the JOBS Act’s crowdfunding provisions, several state legislatures have taken the initiative to enact their own crowdfunding provisions. In the following guest post, Tom Sharbaugh of Morgan Lewis & Bockius LLP takes a look at the concerns that these new state crowdfunding initiatives. 

 

I would like to thank Tom for his willingness to publish his article as a guest post on this site. I welcome guest post submissions from responsible commentators on topics of interest to readers of this blog. Please contact me directly if you are interested in submitting a guest post. Here is Tom’s guest post:  

 

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The new crowdfunding provisions in the “Jumpstart Our Business Startups Act of 2012” (which is often referred to as the “JOBS Act of 2012”) have received a lot of attention, including a piece on this blog earlier this month:  Title III of the Act exempts certain crowdfundings from the registration requirements of the federal securities laws (the “Federal CF Exemption”), and the U. S. Securities and Exchange Commission issued proposed regulations in October 2013 to implement the exemption (the “Proposed CF Regulations”).  The SEC received about 300 written comments to the Proposed CF Regulations, many of which related to the significant costs imposed by the proposed requirements.  The SEC has not yet issued its final regulations despite a directive in the JOBS Act to do so by the end of 2012, and the Federal CF Exemption will not be effective until the SEC does so.  A May 1, 2014 Wall Street Journal article, entitled “Frustration Rises Over Crowdfunding Rules,” describes efforts in the U.S. Congress to amend the JOBS Act even before the Federal CF Exemption takes effect.  However, many states have found a way to go ahead with crowdfunding without the delay and burdens involved with the Federal CF Exemption.  They have done so by adopting their own intrastate crowdfunding exemptions, often citing job creation as the goal.   

 

The state crowdfunding exemptions cannot supersede the actions of the SEC, but there is a longstanding federal exemption from registration for intrastate offerings under Section 3(a)(11) of the Securities Act of 1933, as amended, and SEC Rule 147, which is a “safe harbor” means of compliance with Section 3(a)(11).  States have generally written their new crowdfunding exemptions so that they work in tandem with the federal intrastate exemption.  As explained below, this basically means that an issuer could be exempt at both the federal and state levels if it conducts an offering solely within the state in which it is organized and conducts its business.  The state intrastate exemptions have generally removed certain of the more objectionable requirements of the Proposed CF Regulations, including use of a broker-dealer or “funding portal” for any exempt crowdfunding, preparation of audited financial statements for offerings of over $500,000 and distribution of periodic financial reports to investors after the offering.  In addition, as described below, some of the exemptions have provided routes for raising amounts well beyond the $1 million cap under the Federal CF Exemption. 

 

The federal intrastate exemption has not been very popular because most companies would find it easier to comply with other federal exemptions from registration, such as those provided by Regulation D.  The intrastate offering exemption provides the opportunity for less burdensome crowdfunding for companies that can satisfy the federal intrastate requirements as well as the terms of any intrastate exemptions in their respective home states.  Although Rule 147 is not the exclusive means of complying with the federal intrastate exemption, it is useful because it provides objective standards for compliance.  Consistent with the single-state nature of the exemption, Rule 147 requires the issuer to be “resident and doing business” within the chosen state.  A company can demonstrate residence by being organized and having its principal place of business in the state.  (This may reduce the number of startups that are organized under Delaware law regardless of the locations of their businesses.)   

 

Rule 147 is more challenging with respect to “doing business” within a particular state.  The company must derive at least 80% of its gross revenues from the state, have at least 80% of its assets located in the state prior to any offering, use at least 80% of the net proceeds of the exempt offering to operate a business in the state and locate the principal office of the company in the state.  Rule 147 also requires the company to offer and sell securities only to residents of the chosen state.   

 

The single-state requirements of Rule 147 appear to be written by the economic development agency of a particular state: organize here, conduct most of your business here, use most of the offering proceeds here and locate your principal office here.  However, because much of crowdfunding relates to local projects, the Rule 147 requirements are probably not too objectionable in most crowdfunding situations. 

 

Kansas and Georgia were the first states to take advantage of the Rule 147 option with their “Invest Kansas Exemption” and “Invest Georgia Exemption,” respectively.  Other states with intrastate exemptions from registration, as the result of legislative or regulatory action, include Alabama, Indiana, Michigan, Washington and Wisconsin.   In addition, legislative or administrative action for a crowdfunding exemption is pending in Florida, New Jersey, North Carolina and Texas.   

 

Most of the new state exemptions have the same offering cap as under the Federal CF Exemption–$1 million.  However, some states increase the cap to $2 million if the issuer has audited financial statements (see, e.g., Indiana, Michigan, North Carolina and Wisconsin).  The proposed New Jersey exemption could have a much higher offering cap.  It provides for a limit of $1 million, but it excludes from the cap the amount sold to any “accredited investor” (generally, a natural person with annual income of over $200,000 or a net worth of over $1 million). 

 

All of the state exemptions follow the federal principle that it is advisable to control potential losses by limiting the amount that may be invested by an individual investor.  (It is worth noting, however, that there are no limits on the amounts that may be wagered in legalized gambling.)  Under the Federal CF Exemption, the limitation on investment during a 12-month period depends on the income or net worth of the investor: the greater of $2,000 or 5% of annual income or net worth, if the annual income or net worth of the investor is under $100,000; and 10% of annual income or net worth (not to exceed an investment of $100,000), if the annual income or net worth of the investor is at least $100,000.  The state exemptions have individual investment limitations ranging from $1,000 for Kansas to $10,000 for Georgia, Michigan and Wisconsin, irrespective of the income or net worth of the investor (except for the Washington exemption).  Although no investor can invest over $100,000 under the Federal CF Exemption, the state exemptions generally permit an accredited investor to invest an unlimited amount (subject to the overall cap for the offering). 

 

The Federal CF Exemption preempts state law in most respects, so once the SEC finalizes the regulations for the Federal CF Exemption, U.S. companies that comply with that exemption will be able to engage in crowdfunding in any state.  However, they will not necessarily be able to use the cheaper and quicker intrastate crowdfunding exemptions that will be available only in those states that have adopted their own intrastate exemptions.   

 

The big unknown at this time is whether the availability of an intrastate crowdfunding exemption will bolster entrepreneurial activity in a particular state.  There is already evidence that business groups in states that have intrastate exemptions may use them to recruit businesses from more restrictive states.  A Georgia pro-business group has publicly invited Ohio entrepreneurs to move south where the capital-raising climate is friendlier.   

 

The May 2013 issue of “Fast Company” magazine published a ranking of the “startup cultures” of the states and DC based on a number of factors (“The United States of Innovation”).  Most people would probably expect California (i.e., Silicon Valley) to lead the list with Massachusetts (i.e., Boston) close behind.  The top 10 list includes some surprises: 1. Florida, 2. Texas, 3. Maryland, 4. Arizona, 5. Alaska, 6. California, 8. New York, 9. New Jersey and 10. District of Columbia.  Of these 10 jurisdictions, Florida, New Jersey and Texas have legislation or regulations pending to permit intrastate crowdfunding, but none of the others appears to have taken any action to permit the more liberal exemption. 

 

Many commentators believe that the burdensome requirements of the Federal CF Exemption will defeat the JOBS-Act purpose of making it easier for small companies to raise capital, and as noted above, Congress is already proposing less costly amendments.  The intrastate exemptions adopted by many states appear to provide a reasonable alternative for crowdfunding–an exemption that lacks certain expensive investor protections of the Federal CF Exemption, but that still limits the amount that individuals other than accredited investors could lose. 

 

Tom Sharbaugh is a partner in the Business & Finance Practice Group of Morgan Lewis & Bockius LLP. 

 

delsuppctIn a development with significant implications for the economics of shareholder litigation, the Delaware Supremee Court has upheld the validity of a corporate bylaw provision shifting fees to an unsuccessful litigant. In a May 9, 2014 opinion (here), the Court held in ATP Tour, Inc. v. Deutscher Tennis Bund that a by-law provision shifting attorneys’ fees and costs to unsuccessful plaintiffs in intra-corporate litigation can be valid and enforceable under Delaware law. A May 9, 2014 memorandum from the Paul Weiss law firm said the decision may “dramatically change the landscape of stockholder litigation.”  

 

Background

ATP Tour, Inc. operates the global professional men’s tennis tour. In 2007, ATP revised the tour schedule in a way that affected the annual tennis tournament in Hamburg. Upset about the changes, Deutscher Tennis Bund, an ATP Tour member, sued ATP and its board members in federal district court in Delaware alleging violations of the federal antitrust laws and braches of fiduciary duties under Delaware law. ATP and the individual board members ultimately prevailed on all claims.

 

ATP then filed a motion to recover the fees, costs and expenses it incurred in defending the lawsuit, in reliance on Article 23.3 of ATP’s bylaws, which in pertinent part shifts all litigation expenses to a plaintiff in intra-corporate litigation who “does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought.”  The federal district court determined that the enforceability of this bylaw provision was a novel question of Delaware law that should be addressed in the first instance by the Delaware Supreme Court. The district court certified a series of questions about the bylaw to the Delaware Supreme Court.

 

The May 9 Opinion

In a May 9, 2014 opinion written by Justice Carolyn Berger for a unanimous en banc panel of the Delaware Supreme Court, the Court addressed the federal district court’s certified questions.

 

The Court first observed that there is no prohibition in Delaware’s statutes forbidding the enactment of a fee-shifting bylaw. The Court also noted that while Delaware generally follows the American Rule, pursuant to which each party to a lawsuit bears its own costs, Delaware also allow contracting parties to agree to modify the American Rule to obligate a losing party to pay a prevailing party’s fees. Because corporate by-laws are considered contracts among a corporation’s shareholders, a fee-shifting provision would fall within the contractual exception to the American Rule .Therefore, “a fee-shifting provision would not be prohibited under Delaware common law.”

 

Whether or not ATP’s fee-shifting by-law is enforceable, however, depends on the manner in which it was adopted and the circumstances under which it was invoked. Bylaws that are otherwise facially valid will not be enforced if adopted or used for inequitable purposes. The Supreme Court said that the record certified from the district court did not provide the stipulated facts necessary to determine whether the ATP bylaw was enacted for a proper purpose or properly applied.  The Court said that it is “able to say only that a bylaw of the type at issue here is facially valid, in the sense that it is permissible under [Delaware’s statutes], and that it may be enforceable if adopted by the appropriate corporate procedures and for a proper corporate purpose.”

 

On the questions of what might constitute an “improper purpose,” the Supreme Court noted that “the intent to deter litigation, however, is not invariably an improper purpose.” Fee shifting provisions “by their nature, deter litigation.” An intent to deter litigation “would not necessarily render the bylaw unenforceable in equity.”

 

The Supreme Court concluded its opinion by noting that “fee-shifting bylaw is not invalid per se, and the fact that it was adopted after entities became members will not affect its enforceability.”

 

Discussion 

The Paul Weiss law firm memo linked above notes that the Supreme Court’s ruling was delivered in the context of non-stock corporation, but “the holding may be read to apply to all Delaware corporations.”  The memo goes on to note that whether such a bylaw would be appropriate for a particular corporate “will, however, depend on a number of factors specific to such corporation.” The memo also highlighted the fact that though a fee-shifting bylaw may be facially valid, it may “nevertheless be invalid if adopted or used for an inequitable purpose.”

 

But while there are unquestionably reasons for companies to proceed cautiously, the Delaware Supreme Court’s ruling that fee-shifting by laws can be valid and enforceable under Delaware law potentially presents a significant opportunity for companies organized under Delaware’s laws to try to address the burdens and expense often associated with intra-corporate litigation. Significantly, the Delaware Supreme Court specifically said an intent to deter litigation alone would not be sufficient to render a fee-shifting bylaw unenforceable.

 

The Delaware Supreme Court’s holding in the ATP Tour case is just the latest instance in which Delaware’s courts have upheld companies’ efforts to try to use bylaw provisions to protect themselves from the burdens and costs associated with shareholder litigation. As discussed here, in June 2013, the Delaware Chancery Court upheld the enforceability of a forum selection provision in corporate bylaws designating Delaware court’s as the authorized forum for shareholder disputes. This ruling provided a way for companies to try to protect themselves from the increasingly common curse of multi-forum litigation, particularly in the M&A context.

 

As significant as the ruling the forum selection by-law case was, the Delaware Supreme Court’s upholding the validity of a fee-shifting bylaw could be even more significant. By in effect allowing companies to opt out of the standard American Rule model under which each party bears its own litigation costs, and to adopt the an approac with attributes of the “loser pays” model that prevails in the courts of most other countries, the ruling provides an opportunity for companies to adopt provisions that may protect them from litigation costs, and indeed deter litigation in the first place.

 

It remains to be seen, of course, whether many companies will embrace this opportunity and seek to adopt fee shifting bylaw provisions. Shareholder advocates may resist companies’ efforts to adopt these kinds of provisions. In addition, if it turns out that the adoption of these kinds of provisions affects company share price or creates shareholder relations problems, companies may be reluctant to adopt a fee shifting bylaw.  But while it may be too early too tell whether companies will adopt these kinds of provisions, the possibility that companies could adopt these kinds of provisions has the potential to significantly alter the shareholder litigation environment.

 

I wonder whether a fee-shifting bylaw would require a securities class action plaintiff whose complaint is dismissed to reimburse the company for its defense expenses? If it did, this judicial development in Delaware could turn out to have an enormous significance for corporate and securities litigation.

 

Francis Pileggi’s May 10, 2014 post about the ATP Tour decision on his Delaware Corporate and Commercial Litigation blog can be found here.

googleI am sure most readers were as fascinated as I was by the allegations n the high profile case involving alleged hiring practices among some of the most prominent companies in Silicon Valley. The lawsuit asserted that the companies – including, for example, Apple and Google – had agreed among themselves e that they wouldn’t poach each others employees. The class action lawsuit brought on behalf of the affected employees recently settled.

 

Now shareholders for the companies involved have launched a series of lawsuits alleging that the boards and senior management of the companies involved in the “no poach” arrangements violated their duties to their companies. These latest shareholder lawsuits are a stark example of the way that companies’ employment practices can involve potential liability exposures for the companies’ directors and officers – not just, as is well understood, for violation of the laws directly relating to employment practices, but also for alleged violations of their legal responsibilities as directors and officers.

 

As reflected in the high tech employees’ amended complaint (here), the claimants in the class action lawsuit alleged that Google, Apple, Intel and other companies had reached an agreement not to recruit each others’ employees. The companies’ alleged “no poach” agreement had been the subject of a prior U.S. Department of Justice enforcement action. In their class action lawsuit, the claimants allege that the supposed agreement violated federal and state antitrust laws. According to press reports (refer for example here), the parties to the high tech employee lawsuit recently reached an agreement to settle the lawsuit on the eve of trial for a reported $324 million.

 

Now that the employee lawsuit has settled, attorneys for the shareholders of the companies involved have launched a series of shareholders derivative lawsuits alleging that by entering into the agreements not to recruit other companies’ employees, the executives at those companies violated their legal duties and harmed the companies involved.

 

According to a May 9, 2014 article in The Recorder entitled “No-Poach Pacts Now Basis for Derivative Suits” (here), several separate shareholder derivative lawsuit have now been filed in state court in California against executives of Google,  Apple, Intel and Adobe, each of which companies allegedly participated in the agreement not to recruit each others’ employees.

 

For example, on April 29, 2014, a Google shareholder filed a derivative lawsuit in Santa Clara County (California) Superior Court against thirteen Google executives, including company founders Sergey Brin and Larry Page, as well as against the company itself as nominal defendant. In his complaint (here), the plaintiff alleges that the individual defendants entered or authorized the company’s entry into “express, secret, and illegal non-solicitation agreements with high-level executives at other companies.” These agreements, the complaint alleges, not only hurt the employees but also hurt the companies themselves “because Silicon Valley’s innovation is based in large part on the frequent turnover of employees, which causes information diffusion and spurs innovation.” The complaint seeks to recover damages for the alleged harm done to the companies. The complaint asserts claims against the individual defendants for breach of fiduciary duty; abuse of control; gross mismanagement; and waste of corporate assets. 

 

It is not news that hiring practices involve significant potential liability exposures. But what is interesting about these Silicon Valley no poach practices derivative lawsuits is not just that employee hiring practices have led to significant litigation involving senior management; what is interesting is that claims are not based on alleged violation of employment practices laws, but based on the liabilities arising from the executives’ legal duties to their companies.

 

Unlike the typical lawsuit involving employment practices, the claimants in the derivative lawsuits are not employees or recruits allegedly harmed by the practices; the claimants are the companies’ shareholders. The harm alleged is not the detriments the alleged employment practices caused the employees; the harm claimed is the alleged detriments to the companies themselves. The claims are based not on alleged violations of laws addressing employment practices, but rather are based on the alleged breaches of fiduciary duties.

 

These recent lawsuits involving the Silicon Valley tech companies are not the only high profile examples where corporate hiring practices are raising the possibility of significant potential liability beyond the basic employment practices laws.  According to news reports, the SEC reportedly investigating a number of financial services companies, Including JP Morgan (refer here) and Goldman Sachs (refer here), in connection with allegations that those companies’ hiring practices in China. According to press reports, the SEC is examining whether these companies hired the children of senior government officials to try to curry favor, allegedly in violation of the Foreign Corrupt Practices Act.

 

The recent lawsuits involving the Silicon Valley companies and the SEC investigation of the financial services companies’ hiring practices in China underscore the fact that corporate hiring practices (and other employment practices as well) represent a significant area of potential liability exposure for directors and officers – not just, as is well known and well understood, for potential violation of employment practices laws, but for violations of a broad range of other laws and duties.

 

It is worth noting in that regard that the high tech employees’ class action lawsuit itself was not based on alleged violation of basic employment practices laws. Instead, the employees’ claims were based on alleged violations of antitrust laws. Even the employees’ lawsuit highlights the fact that corporate employment practices can involve a wide range of potential liability exposures beyond those arising from the employment laws themselves.

 

The recent series of lawsuits against the Silicon Valley companies are also illustrative of another recent litigation trend, which is the rising number of civil actions following on in the wake of antitrust investigations and enforcement actions. Here, both the employees’ lawsuit and the later derivative lawsuits followed after the Department of Justice investigation of the companies’ employment practices. As I discussed in a recent post (here), antitrust enforcement is an increasingly important regulatory priority around the world, and increasingly follow-on civil litigation arises in the wake of the regulatory investigations and enforcement actions.

 

For my insurance industry colleagues, there is an additional important point that needs to be emphasized here – that is, the activities under discussion here involve employment practices, but the liability exposure involved is a D&O liability exposure.  The derivative lawsuits filed against the directors and officers are the very kind of lawsuits for which companies purchase D&O insurance. And as I noted above with my reference to the investigation of employment practices in China, employment-related activities can give rise to a wide range of other potential liability exposures. The possibilities of claims arising from employment practices is, as is well understood, significant; but it is perhaps less-well understood that among the liability exposures are D&O liability exposures involving alleged violations of basic director and officer duties.

 

idaho2In a March 20, 2014 decision involving interpretation of the interrelated wrongful acts provision and of the contractual liability exclusion in a bank professional liability insurance policy, District of Idaho Magistrate Judge Ronald E. Bush entered summary judgment on behalf of the policyholder, ruling that the underlying dispute was covered under the policy’s lender liability coverage section.

 

The Magistrate Judge’s interpretation of the interrelatedness issue is interesting because he found that an earlier and a subsequent claim were interrelated despite deposition testimony of the policyholder’s designated representative that the two claims were “not connected” and “independent.”

 

The Magistrate Judge’s noteworthy ruling that the contract exclusion did not apply to preclude coverage here depended on his finding that if applied here the exclusion “would serve to eliminate promised coverage” under the policy’s lender liability coverage section.

 

A copy of the March 20, 2014 opinion can be found here. Hat tip to the Jones Lemon & Graham law firm’s D&O Digest blog for the link to the opinion. The law firm’s May 1, 2014 blog post about the opinion can be found here.

 

Background 

In August 2009, Inland Storage filed a third-party complaint against Idaho Trust Bank over the bank’s alleged refusal to extend promised financing for Inland Storage’s planned 2008 construction of an RV and boat storage facility. Inland Storage’s third-party complaint (referred to in the subsequent coverage opinion as the “2008 claim”) asserted four separate causes of action: breach of contract; breach of the implied covenant of good faith and fair dealing; estoppel; and detrimental reliance.

 

In February 2010, Inland Storage and the bank settled their dispute based on the bank’s agreement to provide Inland Storage with future loans which, if completed, would result in a mutual release of claims. A disagreement later arose regarding the bank’s funding of a loan for Inland Storage to purchase steel for the proposed RV storage facility.

 

In July 2010, Inland Storage filed a second amended third-party complaint against the bank, alleging that the bank breached the settlement agreement by failing to extend the 2010 steel loan. Inland Steel added two counts (counts 5 and 6) to its third-party complaint against the bank, alleging breach of contract and breach of the implied covenant of good faith and fair dealing. (In the subsequent insurance coverage lawsuit, Inland Storage’s claims based on the alleged breach of the settlement agreement were referred to as “the 2010 claim.”)

 

In November 2010, the court in the underlying action granted summary judgment for the bank on Counts 1-4 of the third-party complaint. The court denied summary judgment on counts 5-6 relating to Inland Storage’s claims that the bank had breached the 2010 settlement agreement. A subsequent jury trial resulted in a verdict in favor of the bank.

 

At the time Inland Storage first made its claim against the bank, the bank was insured under an Extended Professional Liability Insurance Policy, which included a lender liability coverage section. This section of the policy provides coverage for a “lending wrongful act,” which the policy defines, in relevant part, as “any actual or alleged error, misstatement, misleading statement, act or omission, or neglect or breach of duty by the company concerning an extension of credit, an actual or alleged failure or refusal by the company to extend credit or an actual or alleged agreement by the company to extend credit.”

 

The policy provided that claims based on interrelated wrongful acts are deemed first made when the earliest claim was made. The policy defined “interrelated wrongful acts” as “wrongful acts that have as a common nexus any fact, circumstance, situation, event, transaction, or series of facts, circumstances, situations, events or transactions.’

 

The policy contained a contractual liability exclusion providing that the insurer is not liable to make any payment for loss for any claims “based upon, arising out of, relating to, in consequence of, or in any way involving … any assumption by the company or an insured person of any liability or obligation under any contract or agreement, or the failure to perform any contract or agreement, unless such company or insured person would have been liable even in the absence of such contract or agreement.”

 

When the bank first submitted the Inland Storage claim to the insurer, the insurer agreed to reimburse the bank for its costs of defense, subject to a reservation of rights under the policy. However, after the November 2010 ruling in the underling lawsuit in which the state court granted summary judgment in favor of the bank with regard to counts 1-4 of Inland Storage’s third-party complaint, the insurer advised the bank that its policy would not cover damages relating to the remaining counts 5 and 6 and specifically that the policy’s contract exclusion precluded coverage for the two remaining claims. The insurer refused to continue funding the bank’s defense in the underlying litigation.

 

The bank filed an insurance coverage lawsuit in Idaho state court alleging that the insurer was required to but had failed to defend and indemnify the bank against the Inland Storage lawsuit. The insurer removed the lawsuit to federal court. The bank and the insurer cross-moved for summary judgment.

 

In its summary judgment motion, the insurer argued that the 2010 claim had been first made after the expiration of the policy period and therefore was not covered under the policy. The insurer also argued that in any event the 2010 claims was precluded from coverage under the policy’s contractual liability provision. The bank argued that the 2010 claim was interrelated with 2008 claim and therefore that the 2010 claim is “deemed” under the policy to have been first made at the time of the 2008 claim. The bank also argued that the contractual liability provision could not be reconciled with the coverage provided in the lender liability coverage section and therefore should not be enforced.

 

The March 20 Opinion 

In his March 20, 2010 Opinion, Magistrate Judge Bush granted summary judgment in favor of the bank and against the insurer, finding that the 2010 claim was interrelated with the 2008 claim and that the contractual liability exclusion could not be enforced to preclude coverage in these circumstances.

 

In arguing that the 2010 claim was not interrelated with the 2008 claim, and therefore was not deemed first made at the time of the earlier claim, the insurer had relied on deposition testimony of the bank’s designated representative, based upon which the insurer contended that the representative had made “admissions” that the subsequent claim was “independent” and “completely, logically not connected” to the earlier claim. The insurer also sought to rely on the summary judgment ruling in the underlying lawsuit, in which the judge in that case had referred to the 2008 and the 2010 claims as representing “two categories of claims.”

 

The Magistrate Judge rejected both of these arguments. The Magistrate Judge reviewed (and reproduced at length in his opinion) the bank’s designated representative’s deposition testimony. The Magistrate Judge agreed that the deposition testimony was “clearly relevant” but “on this record it is not dispositive.” The Magistrate Judge also found that the language from the underlying summary judgment ruling was not determinative, as neither the deposition testimony nor the underlying ruling were addressed to the specific inquiry required by the policy’s definition of interrelated wrongful acts. While the deposition testimony “may offer some piece to be used in that puzzle” and the state court’s opinion may be “useful,” neither is dispositive upon the Court’s interpretation of the insurance policy.

 

The Magistrate Judge went on to conclude that the policy’s definition of “interrelated wrongful acts” describes “a broad range of relationships that is decidedly satisfied here.” The 2008 and 2010 claims, the Magistrate Judge said “share as a common nexus, facts circumstances and events,” adding that “the 2010 claim would not exist but for the attempts to settle the 2008 claim” and that the two claims “involve the same parties, the same lending relationship between the parties and the same underlying subject matter (the steel for [the] proposed RV facility).” The Magistrate Judge concluded that “reasonable minds could not differ as to the conclusion that these two claims were interrelated and according the 2010 claim falls within [the insurer’s] policy period.”

 

The Magistrate Judge also concluded that the contractual liability exclusion did not preclude coverage. The Magistrate Judge said that although the two causes of action identified in the 2010 claim were identified as “breach of contract” and “breach of the implied covenant of good faith and fair dealing,” they both “stem from [the] allegation that Idaho Trust promised to extend a loan and subsequently failed to do so,” which he noted, “falls squarely within the definition of a ‘lending wrongful act.’”

 

Notwithstanding the form in which the 2010 claims were asserted, the contractual liability exclusion is “unenforceable” because it “would eliminate coverage for something otherwise clearly covered under the Policy.” An insurer, the Magistrate Judge said “cannot seek to apply policy limitations and exclusions in a way to defeat the precise purpose for which the insurance is purchased.”

 

The Magistrate Judge went on to note that “while the Court does not find the contractual liability exclusion to render the Policy completely illusory, the Court will not enforce it against Idaho Trust on the particular facts in this case.” The Magistrate Judge emphasized that an insurer “cannot in one section provide coverage or acts that include ‘an actual or alleged agreement’ and then, in another section, attempt to exclude coverage for claims ‘based upon [or] arising out of’ the failure to perform any contract or agreement.” The Magistrate Judge found that the two provisions “cannot be reconciled,” adding that the contractual liability exclusion “frustrates the purposes for which the insurance was purchased and should be strictly construed in favor of Idaho Trust.”

 

Discussion 

With respect to the Magistrate Judge’s determination of the interrelatedness issue, it is on one level not surprising that a court might conclude on this record that the 2008 and 2010 claims are interrelated. However, it is noteworthy that the determination of this issue was so clear – at least to the Magistrate Judge — that the policyholder was entitled to entry of summary judgment in its favor, notwithstanding the arguable contradictory testimony of the bank’s designated representative.  In that regard, the bank’s designated representative’s testimony may not, as the Magistrate Judge said, be dispositive, but it is, as the Magistrate Judge also said, “useful” and a relevant piece in the puzzle.

 

Notwithstanding the potentially relevant and arguably contradictory testimony, the Court nevertheless found no material issue of disputed fact that might otherwise have precluded summary judgment. (I will say based on my own reading of the deposition testimony reproduced in the court’s opinion that it is just about impossible to follow the colloquy between the attorney’s questions and the witness’s testimony, and I am not sure what the witness said or didn’t say).

 

In the end, the Magistrate Judge’s determination of the interrelatedness issue simply corroborates my long-standing view about interrelatedness disputes generally, which is that courts generally approach the analysis of interrelatedness issues with an unconscious bias in favor of whatever outcome will maximize the amount of insurance available.

 

The Magistrate Judge’s ruling on the contractual liability exclusion is more interesting and arguably troublesome. The Magistrate Judge found the contractual liability provision’s preclusive effect to be objectionable and therefore unenforceable because it would “eliminate coverage for something otherwise clearly covered under the Policy.” I have to say that I find this observation just plain odd. Of course the exclusion precludes coverage for something that is otherwise covered under the policy, that is the very purpose of an exclusion from coverage. If the claim were not otherwise covered, there would be no need for an exclusion. Simply put, every exclusion in every insurance policy eliminates coverage for something otherwise clearly covered under the policy. If that alone were sufficient to vitiate policy exclusions, no exclusion in any insurance policy would be enforceable.

 

The Magistrate Judge did say that while the contractual liability provision is unenforceable in this case, the exclusion does not render coverage under the lender liability section “completely illusory;” indeed, in a footnote, he specifically recognized circumstances in which the section could provide coverage that would not be precluded by the exclusion.

 

As the Jones, Lemon & Graham firm noted in its blog post about the case, courts typically will refuse to enforce exclusions on this basis “only when it leaves nothing material covered.” Citing an insurance coverage hornbook stating that “the correct rule … is that an insurance policy does not afford illusory coverage if some material coverage is afforded,” the blog post’s authors note that “there’s nothing illusory about insurance if it provides material coverage, even if an exclusion narrows the coverage grant. The point of an exclusion after all is to narrow coverage.”

 

Regular readers of this blog know that a frequent gripe of mine is the (in my view) overly broad interpretation courts will sometimes give contractual liability exclusions having broad “based upon or arising out of” preambles. (Refer here for an example of a case illustrating this concern.) Notwithstanding my long-standing concern that the exclusion can sometimes be applied overly broadly, I have never thought that the exclusion ought to be unenforceable. Insurers understandably do not feel they should be liable for their policyholder’s voluntary contractual obligation.

 

Significantly the Magistrate Judge did not say the contractual liability provision would be unenforceable in any circumstance, but only “on the particular facts of this case.” In particular, it was the interaction between the definition of “lending wrongful acts” – which definition includes “an actual or alleged agreement by the company to extend credit” – and the contractual liability provision, which precludes coverage for loss based upon or arising out of “the failure to perform any contract or agreement” that is at the heart of the Magistrate’s refusal to enforce the exclusion here. It is the two provisions’ specific references to an “agreement” that troubled the Magistrate Judge.

 

Whether or not the Magistrate Judge’s interpretation of the exclusion will withstand appeal (if any is pursued) remains to be seen. But the Magistrate Judge’s interpretation of the contract exclusion cannot be understood as and was not intended as a comprehensive rejection of the contractual liability exclusion. His unwillingness to enforce the exclusion is specifically relevant only in the context of the lender liability insuring provision and then only in a context in which both the coverage grant and the policy exclusion refer to refer to an “agreement.” For that reason, as interesting as the Magistrate Judge’s ruling is, it is unlikely to prove useful to policyholders seeking to limit the preclusive effect of a contractual liability provision in most other circumstances.  

jetThose interested in trying to identify possible corporate risk indicators will want to take a look at a March 18, 2014 paper by Temple University finance professor Yuanzhi Li and New York University finance professor David Yermack entitled “Evasive Shareholder Meetings” (here). According to the authors’ research, there is a strong negative correlation between distant annual meeting locations and stock price declines over the ensuing six months.

 

The authors’ research was described in a May 8, 2014 New York Times article entitled “Beware When the Annual Meeting in is Moose Jaw” (here).

 

The authors created and studied a data set of 9,616 annual meetings held by 2,542 public companies between 2006 and 2010.  The authors found that most shareholder meetings took place close to company headquarters; over 87% of annual meetings took place within 50 miles of the headquarters.

 

But the authors also noted something very interesting about the companies that held their annual meetings further away. They found a “systematic pattern of poor company performance in the aftermath of annual meetings that are moved a great distance away from company headquarters.”

 

The authors found that companies holding their annual meetings at least 50 miles away from their corporate headquarters and 50 miles away from an FAA large hub airport underperformed the stock market by about seven percent in the following six months. The authors noted that “companies that held long-distance annual meeting experience subsequent abnormal returns that are negative, statistically significant and of large magnitude.”

 

This finding, the authors say, “suggests that management knows adverse news when choosing the location of these meetings, and it may move them far from headquarters as part of a scheme to suppress negative news for as long as possible.” The authors add that “Companies appear to schedule meetings in remote locations when the managers have private, adverse information about future performance and wish to discourage scrutiny by shareholders, activists and the media.”

 

The authors rule out the possibility that the motivation for moving the annual meeting to a distant location was “leisure” or “tourism.” They found that in fact annual meetings only rarely take place at resort locations, and that leisure states like Hawaii and Louisiana have almost exactly the number of meetings predicted by headquarters locations.

 

One example cited in the authors’ study relates to the TRW Automotive Holdings 2007 annual meeting. That year – by contrast the annual meetings held in 2008, 2009 and 2010, which were held in New York – the company held its annual meeting in McAllen, Texas, at the Southern tip of the United States and 1,400 miles from the company’s headquarters outside of Detroit. The authors noted with respect to this meeting: “In line with the results of this study, the company’s stock price fell from $38.97 on the day of the 2007 annual meeting to $25.90 six months later, a drop of 33% during a period when the S&P 500 index fell just 2%.” (The Times article cited above quotes a TRW spokesman as saying that the company has a warehouse in McAllen and stating that the downturn was “really more about timing” and that the company has since had a robust recovery)

 

Interestingly, stockholders do not seem to have “decoded” that a remote annual meeting location flags future adverse results, since the company share price for companies with far-flung annual meetings generally does not decline at the time the meeting is announced, but only after the meeting has taken place. As the authors note, “it is less obvious why shareholders fail to decode such an unambiguous signal at the time the meeting location is announced.” (The Times article quotes Broc Romanek of the TheCorporateCounsel.net  (here) as saying that since most annual meetings are “purely perfunctory,” a remote location “is a clear signal that the company does not respect its shareholders.”)

 

The authors’ conclusions are valuable for shareholders interesting in understanding factors that may indicate future share price directions. The authors’ conclusions may also provide useful insight for D&O insurance underwriters. Of particular interest is the authors’ conclusion that the selection of a remote annual meeting location may predict adverse but not yet disclosed financial information that could have a negative impact on the company’s share price. In light of this observation, D&O underwriters may want to consider looking into the location of the company’s annual meeting, particularly if it has not yet taken place. An annual meeting venue far from corporate headquarters could represent a possible risk indicator.

wyndham1 In what is the latest example of the potential cybersecurity-related liability of corporate boards, a shareholder for Wyndham Worldwide Corporation has initiated a derivative lawsuit against certain directors and officers of the company, as well as against the company itself as nominal defendant, related to the three data breaches the company the company and its operating units sustained during the period April 2008 to January 2010. As discussed here, the company is already the target of a Federal Trade Commission enforcement action in connection with the breaches.

 

According to a May 6, 2014 Law 360 article (here, subscription required), the derivative lawsuit plaintiff, a Wyndham shareholder, first filed the action in the District of New Jersey in February 2014, but a redacted version of the complaint was only just made public on May 2, 2014 “shortly after a magistrate judge ruled that certain confidential business information contained in the complaint would cause irreparable harm to Wyndham if it were fully unsealed.” The public version of the complaint, which is extensively redacted, can be found here.

 

As discussed in my prior post concerning the FTC regulatory action, the company’s three data breaches allegedly resulted in the compromise of more that 619,000 consumer payment card account numbers, many of which were subsequently exported to a domain registered in Russia, allegedly causing fraudulent charges and more than $10.6 million in fraud loss.

 

In its enforcement action, the FTC alleges that “alleged failure to maintain reasonable and appropriate data security for consumers’ sensitive personal information” violated the prohibition in Section 5(a) of the Federal Trade Commission Act of “acts or practices in or affecting commerce” that are “unfair” or “deceptive.” The FTC’s lawsuit seeks to compel the company to improve its security measures and to remedy any harm its customers have suffered. In an April 7, 2014, District of New Jersey Judge Ester Salas denied the defendants’ action to dismiss the FTC complaint upheld the FTC’s authority to bring the action.

 

In the derivative lawsuit complaint,  which was originally filed in February 2014, before the recent ruling upholding the FTC’s authority, the plaintiff alleges that “in violation of their express promise to do so, and contrary to reasonable expectations,” the company and its subsidiaries “failed to take reasonable steps to maintain their customers’ personal and financial information in a secure manner.” The complaint alleges further that the individual defendants “failed to ensure that the Company and its subsidiaries implemented adequate information security policies,” and that the Company’s property management system server “used an operating system so out of date” that the company’s vendor “stopped providing security updates for the operating system more than three years prior to the intrusions” and allowed the company’s software to “be configured inappropriately.”

 

The complaint goes on to allege that the individual defendants “aggravated” the damage to the company by “failing to timely disclose the breaches in the Company’s financial filings.” The complaint notes that the company did not first disclose the breaches until July 25, 2012, over two-and-a-half years after the third breach occurred.

 

The complaint alleges that the defendants’ failure to implement appropriate internal controls designed to detect and protect repetitive data breaches “severely damaged” the company and resulted in the FTC enforcement action noted above. The FTC action, the complaint notes, “poses the risk of tens of millions of dollars in further damages.” The company’s failure to protect its customers’ personal information “has damaged its reputation with its customer base.” The complaint alleges that the plaintiff has brought the action “to rectify the conduct of the individuals bearing ultimate responsibility for the Company’s misconduct – the directors and senior management.”

 

The complaint asserts substantive claims against the individual defendants for breach of fiduciary duty; corporate waste; and unjust enrichment. The complaint seeks recovery of the damages the company allegedly has suffered; remedial action with respect to corporate governance and internal procedures; and disgorgement of profits and compensation.

 

Discussion

 As I noted earlier this year when Target Corp.’s board was hit with two derivative lawsuits relating to that company’s massive data breach at the end of 2013, the risks and exposures companies face in connection with cybersecurity issues include potential liability exposures for companies’ corporate boards. And in my earlier post about the FTC’s enforcement action against Wyndham, I noted that exposures a company faces in the wake of a cyber breach include the risk of a regulatory enforcement action. As this latest derivative lawsuit filings shows, the risk of a regulatory enforcement action also includes the possibility of a follow-on civil action filed it the regulatory action’s wake.

 

The action against the Target board and this action against the Wyndham directors and officers are of course similar in that they both relate to cyber breaches the companies sustained. The actions are also similar in that both actions referred to the ways that the respective companies publicly disclosed information relating to the breaches. This feature of these lawsuits underscores that the potential liability exposures facing corporate boards includes not only the risks associated with cyber breaches themselves, but also includes potential exposures based on the way that the company reacts to the breach and manages its affairs after the breach.

 

In my discussion of the FTC’s enforcement action against Wyndham, I noted some of the potential coverage issues under a variety of types of policies that might limit the amount of insurance potentially available to protect the company with respect to the type of enforcement action the FTC filed. However, the derivative lawsuit represents a more conventional D&O claim, and is the kind of lawsuit that the traditional D&O insurance policy is designed to protect against. Certainly, all else equal, the directors and officers would expect to have their fees incurred in defending against this claim to be funded under their D&O insurance policy.

 

There potentially could be some issues relating to the claims made date, as the question will arise whether this claim was first made in February 2014 when the derivative complaint was first filed, or whether it relates back to the earlier date when the FTC action was first filed.

 

It remains to be seen how the plaintiffs in this action and in the Target action fare. These cases may or may not prove to be successful for the plaintiffs. However, I think it is highly likely that we will continue to see more lawsuit of this type filed, particularly in connection with higher profile data breaches.

 

As these types of cases become more common, it will be interesting to see how the D&O insurance marketplace responds. At a minimum, it can be anticipated that carriers increasingly will include cybersecurity and cyber breach issues in the D&O insurance underwriting. Some carriers may even take more active steps to try to limit their exposures to cyber-related D&O exposures. At least one leading carrier has already started including privacy and network security exclusions on its management liability insurance policies issued to health care service companies. Other carriers may start to try to take defensive measures of this type.

 

I am going to go out on a limb here and say that I think cyber breach-related issues are going to represent an increasingly important liability exposure for corporate directors and officers – and for their insurers.