In recent years, Stanford Law School Professor Michael Klausner has led research on several critical issues involved with class action securiteis litigation and SEC enforcement actions.In the guest post below, Professor Klausner and his colleague Jason Hegland describe the two databases they have built in support of their research efforts and detail some additional findings their research has produced. The authors also invite comments and inquirites regarding their research tools and their analysis. I would like to thank Professor Klausner and Jason Hegland for their willingness to publish their article on this site. Here is their guest blog post: 

 

            In two recent articles in the PLUS Journal, we presented some simple statistics from the database we have been building over the past few years. One article is on the extent to which D&O insurance proceeds are paid into settlements. The other is on the timing of settlements and dismissals. The two articles can be found on the PLUS website through their search bar or here and here. Our plan is to follow up with a series of more detailed and sophisticated statistical analysis of both securities class actions and SEC enforcement actions. In this post, we summarize some additional findings and invite comments from those of you who are involved in litigating, underwriting, brokering, and paying claims. We begin by describing two databases that we have built and which we intend to maintain going forward. One covers securities class actions and the other covers SEC enforcement actions.

 

The Securities Class Action Database

            This database covers all securities class actions since 2000 and includes over 50 categories of data. The basic data items include, for example:

 

·        Names and positions of all individual defendants

·        Names of third party defendants

·        Names of lead plaintiffs and lead counsel

·        Comprehensive case history, including details of all complaints filed, motions to dismiss and for motions summary judgment.

·        Settlements, including individual payments, third party payments, and attorneys’ fees

·        Courts and judges

 

In addition, we have some unique data points:

 

·        The amount that insurers paid into settlements

·        The stage of the proceedings at which a case settled (e.g. before the first motion to dismiss was ruled on, after the first motion was ruled on but before a later motion was finally denied)

·        The nature of the misstatement (e.g. financial or nonfinancial misstatement, restatement involved) 

·        Evidence of scienter alleged (e.g. insider sales, confidential witnesses, parallel regulatory actions)

 

 

The SEC Enforcement Action Database

            Our database on SEC enforcement actions covers civil and administrative actions involving public company misstatements filed from 2000 forward.  The following are some examples of the data we have collected:

 

·        Names of all individual, corporate and third party defendants

·        Specific violations alleged (e.g. Sections 10(b), 17, 13(b)(5)).

·        Allegations regarding evidence of scienter

·        Whether cases were tried, settled or dismissed

·        Case history

·        Timing of settlement (e.g. upon filing, following motion for summary judgment)

·        Penalties imposed on each defendant in settlement or following trial

·        Courts and judges

 

Some Findings Regarding Dismissals

            Dismissal rates range from 31% to 59% in any given year. Among cases filed in the years 2000 through 2005, 39% were dismissed, and among cases filed in the years 2006 through 2010, 45% of cases were dismissed. This difference, however, is not statistically significant.

 

Most cases (68%) were resolved on the basis of a single consolidated complaint. Thirty percent of cases were either dismissed with prejudice on the basis of the first consolidated complaint, or dismissed without prejudice and not refiled.  Nine percent of cases were voluntarily dropped before the motion to dismiss was made.  So a total of 37% of cases were dismissed or dropped without a second consolidated complaint being filed. Another 31% of cases were settled either before the ruling on the first motion to dismiss or after the ruling but before a second complaint was filed. 

 

Courts vary somewhat with respect to dismissals, but since the nature of cases varies geographically, it is difficult to separate the court from the nature of the case. Figure 1 below shows the distribution of final dismissals (with prejudice) across first, second and third consolidated complaints for the four high-volume courts and for the remainder of courts as a group. Of the courts with a relatively high volume of securities class actions, the Southern District of New York dismisses cases disproportionately on the basis of the first consolidated complaint, and it rarely allows a plaintiff to file a third consolidated complaint. The other three high-volume courts more frequently give plaintiffs more opportunities to file second or third complaints. In the remainder of the country, courts are similar to the SDNY.

 

Figure 1

 

Some Findings Regarding the Timing of Class Action Settlement

            Because the timing of settlements has a substantial impact on the cost of litigation, we collected detailed data on when settlements occur—at what stage of the litigation process and after how much time has passed. To simplify the presentation here, we divide the litigation process into three phases:

 

·        Early Pleading: Anytime prior to a ruling on the first motion to dismiss.

·        Late Pleading:   After the first motion to dismiss has been granted without prejudice but before a later motion has been denied. This is the period during which a plaintiff is filing a second or later consolidated complaint.

·        Discovery: Anytime after a motion to dismiss has been denied and a case heads into discovery. This phase includes cases settled soon after the motion has been denied and cases that settle on the eve of trial or even pending appeal.

 

Roughly half of all settlements occur in one of the two pleading stages—that is, before a court has finally denied a motion to dismiss and allowed a case to proceed to discovery. The other half of settlements occur after the motion has been denied and a case heads toward discovery. Among those cases, on average, settlement occurs 16 months after the motion was denied. 

 

            As shown in Figure 2, there is a slight difference in settlement timing across courts, with cases in the Central District of California settling in the Early Pleading Phase more often than cases in other court, and cases in the Northern District of California settling in the Discovery Phase more often than in other courts. These differences do not seem to be related to the patterns we see above with respect to differences in dismissals across courts.

 

Figure 2

           

D&O insurer payments into settlements also vary with settlement timing. This is shown in Figure 3, below. The lowest percentage paid is for settlements at the Early Pleading Stage, which is probably attributable to retentions. Earlier settlements tend to be lower than later settlements (though not across the board), and of course litigation expenses are lower for cases that settle early. An interesting finding, however, is that across settlements in all phases, insurer contributions to settlements were higher among cases filed in the second half of the past decade than in the first half. Figure 3 shows insurer contributions across the three phases for cases filed between 2000 and 2005 and cases filed from 2006 to 2010. (Many cases filed after 2010 are still ongoing, so we omit those).

 

Figure 3

 

Individual Liability in Class Actions and SEC Enforcement Actions

            Individual liability is obviously a concern of directors and officers. In earlier research, one of use showed that outside directors’ risk of liability is extremely low, in class actions or in any other type of suit.  Officers make made out-of-pocket contributions to class action settlements more often. In cases filed from 2006 to 2010, officers made payments into settlements in 2% of settlements (less than 1% of all cases filed).  It is difficult to say whether these were cases where evidence of misconduct was strong, but to get some perspective on whether individual liability is a danger in the absence of strong evidence, we look at officers’ payments in class actions with parallel SEC actions—cases presumably with relatively strong evidence of misconduct. As shown in Figure 4, among the 60 pairs of resolved cases filed between 2006 and 2010 in which the SEC imposed a serious penalty, there were only 5 class actions in which the officers made an out-of-pocket payment. This suggests that even when the merits are relatively strong in class actions, the likelihood of a personal payment is low.

 

Figure 4

 

            In class actions, the mean and median individual payments are $11.7 million and $600,000, respectively. In SEC actions, penalties against individuals involved in the 60 cases reflected in Figure 4 are shown in Figure 5, below.

 

Figure 5

 

Note: Frequencies refer to cases, which can involve multiple defendants. Means and medians refer to penalties per person.

 

 

Finally, we thought data on the duration of SEC actions, once filed, would be of interest. The mean and median duration of a case against an individual officer (as opposed to cases against the company, which settle more quickly) are 14 months and 8 months, respectively. This, however, includes a large number of cases that are settled simultaneously with filing or within a month of filing. Figure 6 provides a more detailed breakdown. Note, however, that these figures do not include the length of time that the SEC spends investigating a case.

 

 

Figure 6

           

          We have provided here a relatively small sampling of the sorts of basic information we can extract from our database. We would welcome comments, questions, and explanations on what we have described here as well as questions that D&O Diary readers think would be interesting to address with the data we are collecting. We would be happy to follow up with additional blog posts.

                                                                                                 

There days, virtually every M&A transaction attracts litigation, usually involving multiple lawsuits. These cases have proven attractive to plaintiffs’ lawyers because the pressure to close the deal affords claimants leverage to extract a quick settlement, often involving an agreement to publish additional disclosures and to pay the plaintiffs’ attorneys’ fees.

 

As Doug Clark of the Wilson Sonsini law firm notes in his June 6, 2013 article, “Why Merger Cases Settle” (here), there is a “general perception” — which he describes as “accurate” — that “the lawsuits are just opportunistic strike suits that amount to tax on sound transactions.” Clark asks, given this general perception that these cases “have no merit,“ why do they usually settle? Why are the parties willing to pay off the plaintiffs’ lawyers and increase the transaction costs of the deal for lawsuits they perceive to be meritless?

 

Clark suggests two reasons the cases settle. The first is that the litigation is time=consuming and expensive. Most targets of this type of litigation just “want someone to make it go away,” and the settlement allows the defendants to avoid the irksome and expensive litigation activity. Based on these considerations, the decision for most defendants in this type of litigation is “pretty clear” because “settling makes a lot of sense.”

 

But, according to Clark, there is a second reason these cases settle. Clark’s observations about this additional reason is the more interesting part of Clark’s analysis. According to Clark, another reason the cases settle is that post-merger litigation can drag on interminably because it can be difficult to resolve. The difficulty of resolving the litigation post-close provides another incentive for the defendants to try to resolve the case prior to the transaction closing.

 

As Clark points out, if the plaintiffs fail as an initial matter to enjoin the transaction and the deal closes, the case isn’t over – the litigation often continues. (Indeed, as Clark’s partner at Wilson Sonsini, Boris Feldman, noted in a November 9, 2012 blog post on the Harvard Law School Forum on Corporate Governance and Financial Reform, here, at least some plaintiffs’ lawyers have “refined their business model” and now they aim to “keep the litigation alive post-close.”)

 

There are a number of reasons why the post-close case can be difficult to resolve. The first is that the post-merger case is neither time-sensitive nor interesting. There is no longer any sense of urgency. The defendants may begin to feel “disconnected” from the case, which is “unsurprising as the company at issue and the board seats of the defendant directors no longer exist.”

 

Another reason that it is harder to settle the case post-close is that the acquiring company and its officers and directors are in charge of the case after the merger. The acquiring company’s directors are not defendants and so the dynamics change.

 

A third reason the post-merger cases are “very difficult, if not impossible, to settle” is that the easy settlement options available prior to the merger (like agreeing to some additional disclosures in the proxy) are no longer available. The most “obvious way” to settle the case post-close is to increase the amount that the acquiring company pays for the target, with the additional amounts to be distributed to the shareholders of the acquiring company. The problem with this option is that increased deal consideration will not be insured under the acquired company’s D&O policy – though the ongoing defense fees will be.

 

Because the defense fees are covered, the continuing case is not a burden on the acquiring company, but if the acquiring company were to increase the deal consideration post-close in order to try to resolve the case, it would be to “the detriment of their balance sheet, share prices and stockholders.” At the same time, however, there is a risk to the directors of the acquired company if the case does not settle and if it were to go to trial; there could be liability determination that would preclude the directors’ indemnification and insurance.  

 

As Clark puts it, given “the difficulty of settling cases post-close, and the risk of a judgment that is neither insurable nor indemnifiable, one understands why merger cases settle before the deal closes.”

 

Clark proposes a number of ways to try to address this situation. He suggests amendment to the Delaware appraisal statute, to encompass post-merger claims. This remedy would entail a post-merger appraisal of the shares as the exclusive remedy for post-merger claims. In order to be a member of the post-merger appraisal class, the claimant would be required to vote “no” on the merger or to decline to tender shares in response to a tender offer.

 

As an alternative to this appraisal remedy, Clark suggests changing Delaware law to limit the classes of persons who can pursue post-merger claims to those who voted “no” on a merger or who did not tender their shares. This would “limit theoretical damages” and reduce the plaintiffs can extract from the mere continued existence of the claim.

 

Clark suggests another option, which is to make the class a post-merger claim an “opt-in” class (as opposed to the current procedural model where classes are organized on an “opt-out” basis) This would require prospective class members to affirmatively choose to be a part of the class.

 

Another suggestion is to “take a harder look at the plaintiffs in these cases to see if they are proper representatives” and that they are “bona fide plaintiffs,” as “the merger litigation landscape is littered with “bad plaintiffs” who may be small holders with no real financial interest in the case or repeat “professional” plaintiffs who serve as “nothing but a figurehead for plaintiffs’ counsel.”

 

Finally, Clark suggests that Delaware should (as California and other states already do) make the post-merger consideration cases derivative cases so that post-merger the plaintiffs would lose their derivative plaintiff standing, as they are no longer shareholders.

 

Clark’s observations about the difficult of settling cases post-merger and the incentives these difficulties provide the defendants to try to settle the cases prior to the merger are interesting. His description of the post-close dynamics and the difficulties they create to try to settle the cases are quite sobering. It is hard to read this description without reaching the conclusion that something has to change.

 

Clark’s proposed solutions are also quite interesting, even creative. However, they also represent significant legal or procedural changes. The magnitude of the change required could be a barrier, as legislatures might draw back from changes to remedies or established procedures. However, even if the Delaware legislature were willing to go along, the changes would only prove beneficial when the post-merger litigation goes forward in Delaware. Plaintiffs’ lawyers, eager to circumvent these kinds of restrictions, would have every incentive to press their litigation elsewhere.

 

One of the great curses of the current wave of M&A-related litigation is that competing groups of plaintiffs are already pursuing litigation in multiple jurisdictions. If Delaware’s legislature were to make its courts less amenable to post-merger cases, the various plaintiffs would have even greater incentives to press their claims outside Delaware.

 

Just the same, there is still good reason to consider trying to implement reforms. Perhaps if Delaware were to take the lead, others states might follow. Of course, even that optimistic outcome would take considerable time, and meanwhile the curse of post-merger litigation would continue.

 

For now, many litigants caught up in post-merger lawsuits may conclude they have only one practical alternative to costly capitulation – and that is to fight these cases. Indeed, that is the suggestion raised by Clark’s law partner, Boris Feldman, in his earlier blog post cited above. Feldman suggests that defendants may want to push for summary judgment; he suggests that more courts may be willing to grant summary judgment in post-close cases. Feldman argues that owing to the general weakness of these cases and the scope of the exculpatory provisions in the Delaware Corporations Code, even if the plaintiffs keep their cases alive post-merger, they will have difficulty figuring out “a way to monetize them that survives judicial scrutiny.”

 

Though there are legislative reforms that might help and though fighting the cases might be successful, the likelier outcome for now is that defendant companies caught up in these kinds of cases will, as the plaintiffs’ undoubtedly hope, tire of the cases and seek some type of compromise — which increases the likelihood that the plaintiffs will continue to file these cases and continue to pursue them, even post-merger.

 

We can only hope that eventually a consensus will emerge in legislatures or the courts to make this racket less rewarding for the plaintiffs’ lawyers.  

 

D&O Insurance for U.S.-Listed Chinese Companies: As readers of this blog well know, securities class action lawsuits against U.S.-listed Chinese companies surged in 2011 and even continued into 2012. As a result of this flood of litigation and of the nature of the accounting violations raised in many of the cases, “the cost of insurance to cover directors and officers of Chinese companies against lawsuits has skyrocketed,” according to a June 17, 2013 Bloomberg article entitled “Directors Refuse to Go Naked for Chinese IPOs” (here).

 

The article details the way that the insurance marketplace reacted to the surge in litigation involving Chinese companies. The article further describes how, as the insurers cranked up the rates and restricted coverage, some Chinese companies reacted by scaling back their coverage, by acquiring insurance with lower limits of liability. However, the article quotes several non-Chinese members of Chinese company corporate boards as saying that they would refuse to serve if their companies did not carry D&O insurance (that is, if their companies went “naked”).

 

These questions about the cost and availability of coverage for U.S. companies have taken on a renewed relevance as Chinese companies now return to the U.S. for listings on the U.S. exchanges. According to the article, there has already been one U.S. IPO of a Chinese company in 2013, and apparently there are more in the pipeline. Even though the wave of scandals involving U.S.-listed Chinese companies appears to have played itself out, these new IPO companies continue to have to pay “about two-to-three times more than what a comparable U.S.-domiciled company would pay.” Just the same, according to commentators quoted in the article, some carriers “are going back in” to the marketplace for U.S.-listed Chinese companies.

 

From my perspective, the article’s general observation about the D&O insurance market for U.S.-listed Chinese companies is more or less accurate. Insurers continue to perceive Chinese companies as a tough class of business. The article is also accurate when it says that some Chinese companies reacted to the price rises by cutting back. Indeed, in some instances, the companies simply declined to purchase the insurance because they found it so costly. However, companies that take that step will have difficulty attracting and retaining the most highly qualified non-Chinese directors, who, like several individuals quoted in the article, will refuse to serve if the company “goes naked” and discontinues its D&O insurance. 

 

Cyber security and related privacy issues increasingly dominate the headlines. And for good reason: according to statistics cited in a recent Wall Street Journal article, cyber attacks –ranging from malicious software to denial of service attacks – increased 42% in 2012. The trend has only accelerated in 2013. As the possibility and potential scope of these types of attacks increases, these issues represent an increasing challenge for all companies and their management – and increasingly, their boards, as well.

 

The banking industry is the latest to receive the emphatic message that companies need to be taking steps to protect against cyber threats. According to a June 14, 2013 Wall Street Journal article entitled “A Call to Arms for Banks” (here), regulators are “stepping up calls for banks to better-arm themselves against the growing online threat that hackers and criminal organizations pose.” Regulators are increasingly concerned about attacks that might not only disrupt an individual bank but also the entire financial system.

 

Among other things, the Journal article reports that the OCC recently hosted a call with more than 1,000 community bankers “warning that cyber attacks are on the rise – particularly among small banks – as the number of potential targets expands.” Among other things, the banks were advised that they will be “judged on their preparation against cyber attacks when examiners gauge a bank’s operational risk.”

 

The message from regulators is not only that they expect the regulated institutions to take steps to guard against cyber exposures, but that the institutions will be held accountable for their shortcomings in this area. The expectations and the accountability are not limited just to the banking sector. According to the Journal article, last year the FTC filed a lawsuit against Wyndham Worldwide Corp. alleging that the hotel chain “failed to protect the credit-card information of its consumers.” (For those readers who may be interested, the FTC’s complaint in the action against Wyndham can be found here. )

 

Yet another recent Journal article underscored the extent to which cyber exposure involves companies in many industries. In a disturbing June 13, 2013 article entitled “Patients Put at Risk by Computer Viruses” (here), the Wall Street Journal reported the apparently increasing risk that medical devices could be infected with viruses or malware that could impair the devices’ function or expose potentially sensitive patient information by sending it to outside servers. The article cites several examples including an instance where in infected radiology device was sending mammography information to outside servers, including patent names, records of procedures and X-ray images.

 

These latter examples underscore how extensive and dispersed cyber threats have become in an era where devices are increasingly interconnected. Moreover, it is clear that regulators (among others) expect companies to take steps to protect against cyber exposures – and that regulators intend to hold companies accountable.

 

Given the extent of the operational and reputational risk that cyber exposures represent, these issues should be a priority topic for company managers – and for company boards. As on any other critical topic, directors should be asking questions and demanding accountability.  This is going to be particularly true for companies whose products might be involved in the kinds of cyber incidents described in the Journal article about infiltrated medical devices.

 

In this environment, directors should be asking the questions to determine what steps their company is taking to assess and to protect against cyber exposures. One particular question directors should be asking their senior managers is what steps the company has taken to put insurance in place to protect against the problems that can arise when cyber incidents occur.

 

In the guidance that the SEC recently provided companies with respect to cyber-related disclosures, one item the SEC specifically emphasized that companies should be disclosing with respect to their potential cyber exposures is a “description of relevant insurance coverage.” Behind this disclosure requirement is the implicit assumption that companies will have insurance in place to respond to cyber incidents. With regulators bearing down on these issues and even filing regulatory actions, it is a matter of simple prudence for companies to have insurance in place designed to address these risks.

 

For that reason, as part of their overall assessment of these issues, directors will want to ask company management what insurance the company has in place to protect their company from loss arising from cyber-related exposures. In particular, because traditional insurance alone is not sufficient to protect against these risks, directors should determine that the company has a cyber liability insurance policy in place that provides protection against both first party costs (such as forensic IT services, notification costs, call center costs, and credit monitoring services) and third –party costs (such as might arise in a third-party liability lawsuit.

 

A good introductory summary to the limitations of traditional insurance and the need for the specialized cyber liability insurance to protect against these risks can be in a two part series by Roberta Anderson of the K&L Gates law firm entitled “Insurance Coverage for Cyber Attacks, ” which can be found here and here.

 

ICYMI: SEC Make Second Whistleblower Award: On June 12, 2013, the SEC made its second award under the Dodd-Frank whistleblower provisions. Under the provisions, whistleblowers whose tips to the SEC lead to enforcement judgments and awards over $1 million are potentially eligible for an award of from 10 to 30 percent of the sanctions. As reflected here, the SEC made its first award on August 21, 2012.

 

In a June 12, 2013 order in a Whistleblower Award Proceeding (here), the SEC determined that each of three whistleblowers is to receive an award of five percent of monetary sanctions collected. The three unnamed individuals had “voluntarily provided original information to the Commission that led to the successful enforcement” of an action against Audrey C. Hicks and Locust Offshore Management. (The SEC denied a whistleblower bounty award to a fourth person). In the enforcement action, which resulted in disgorgement and penalties total about $7.5 million, the SEC alleged that the defendants had sold shares in a fictitious offshore fund. The SEC’s press release announcing the award can be found here.

 

Even though the recent award was relatively modest and is only the second so far under the Dodd-Frank whistleblower provisions, observers believe the award indicates further awards will soon be forthcoming. Indeed, as reported in Bruce Carton’s June 12, 2012 Compliance Week article (here), the SEC official in charge of the agency’s whistleblower program recently told an industry conference that in the coming months the whistleblower program will produce “incredibly impactful cases” with “some extremely significant whistleblower awards.”

 

Upcoming Securities Litigation Webinar: On Wednesday June 19, 2013, at 2:00 am EDT, Financial Recoveries Technologies will be hosting a webinar entitled “The Evolving Securities Class Action Industry.” This free webinar will address the legal environment affecting class actions, fiduciary obligations for asset managers and standards in the claim filing industry. Speakers will include Boston University Law Professor David Webber, who recently posted an interesting article entitled “Institutional Investor Lead Plaintiffs in Mergers and Acquisitions Litigation” on the Harvard Law School Forum on Corporate Governance and Financial Regulation. The webinar panel will also include our good friend Adam Savett, who is CEO and Founder of TXT Capital. Registration Information for the webinar can be found here.

 

As I discussed in a recent post (here), in a June 11, 2013 opinion, the New York Court of Appeals held that J.P Morgan (which had acquired Bear Stearns) is not barred from seeking insurance coverage for a $160 million portion of an SEC enforcement action settlement labeled as “disgorgement,” where Bear Stearns’ customers rather than Bear Stearns itself profited from the alleged misconduct. The Court of Appeals opinion can be found here.

 

In the following guest post, Peter Gillon of the Pillsbury law firm offers his views about the Court of Appeals opinion in the J.P Morgan case, as well as about the decision’s implications. Readers are encouraged to add their comments on Peter’s guest post using the comment feature in this blog’s right hand column. I would like to thank Peter for his willingness to publish his article on this site. I welcome guest posts from responsible commentators on topics of interest to this site’s readers. Please contact me directly if you are interested in publishing a guest post. Here is Peter’s guest post:

 

In a case closely watched by industry observers, the New York Court of Appeals, in J.P. Morgan Securities v. Vigilant Insurance Company, No. 113 (NY, June 13, 2013), issued an important ruling in the field of Directors & Officers Liability Insurance, curtailing to some extent insurers’ ability to use a phantom exclusion to deny coverage. Insurers increasingly have argued that their policies do not cover damages that can be characterized as restitutionary in nature, even where the policy may be silent on the issue. The contention is based on two theories: (1) that notwithstanding contract language providing coverage, the policy is unenforceable in that respect because in some states coverage for damages in the form of restitution (or disgorgement of ill-gotten gains) is unenforceable as a matter of public policy; and (2) from an economic standpoint, when a policyholder returns monies it has obtained improperly, there is no basis for coverage because the policyholder has not incurred any “Loss.”

 

The New York high court called foul on this encroachment on policyholders’ contractual rights, holding that policyholder Bear Stearns was entitled to pursue its claim to coverage for a $160 million payment incurred as a result of settlement of an SEC enforcement proceeding, even though the agreement expressly characterized the payment as “disgorgement.” As the Court made clear, there is no public policy in the State of New York barring coverage for restitution or disgorgement; and the limited public policy exception to the enforceability of contracts for “intentionally harmful conduct” could not be sustained by insurers on the record before the court. (Slip Op. at 9-11). More important to policyholders, the Court also held that the bulk of the payment characterized in the settlement agreement as “disgorgement” was actually compensation for profits improperly received by Bear Stearns’ hedge fund customers, not the result of gain by Bear Stearns. Given that the “policy rationale for precluding indemnity for disgorgement – to prevent the unjust enrichment of the insured by allowing it to, in effect, retain the ill-gotten gains by transferring the loss to its carrier,” was not implicated because Bear Stearns was “not pursuing recoupment for the turnover of its own improperly acquired profits,” the Court denied insurers’ motion to dismiss. As Justice Smith put it during oral argument before the appellate court, “how can you disgorge something that you haven’t ‘gorged’?”

 

The ruling is critically important in that it curtails the use of the unwritten “restitution defense” by D&O insurers subject to New York law, unless the restitution payments at issue corresponded to benefits actually received by the insured. Under this test, the restitution defense would not apply to any claim, such as a claim for breach of fiduciary duties by directors or officers, where the individuals did not receive the benefit of a distribution or other transaction. Likewise, this matching test should limit use of the restitution defense in response to Side B claims (reimbursing a company for amounts paid as indemnity to individual directors or officers), where the company has paid restitution to a third party, but individual directors or officers did not actually benefit from the funds being disgorged.

 

Left unaddressed by the New York court, however, is one of the nagging issues in this area: whether the restitution defense requires the insurer to prove not only that the insured was the actual beneficiary of the amount being disgorged, but also that the gains were “ill-gotten.” In many cases, the recipient actually earned the amounts being disgorged, lawfully and properly, but is required to turn over its gains for technical legal reasons, regardless of fault. This may occur in a fraudulent transfer action brought by a bankruptcy trustee under Section 548 of the Bankruptcy Code (allowing avoidance of certain types of payments, such as severance payments to executives, made by an insolvent company less than two years prior to the bankruptcy petition date, in return for less than reasonably equivalent value). At least one court has held that in a fraudulent transfer action brought by a debtor company’s bankruptcy trustee against the company’s former CEO, the employee severance payment the CEO was ordered to disgorge did not constitute “Loss” within the meaning of the D&O policy. In re Transtexas Gas Corp., 597 F.3d 298, 310 (5th Cir. 2010)(“Payments fraudulent as to creditors that must therefore be repaid due to bankruptcy court order [are] a disgorgement of ill-gotten gains and a restitutionary payment.”). Other courts have rejected such an approach as an overbroad application of vague notions of public policy. In Federal Ins. Co. v. Continental Casualty Co., 2006 WL 3386625 (W.D. Pa. Nov. 22, 2006), a case arising from an action to recover alleged fraudulent transfers to former directors and officers under the Bankruptcy Code, the court refused to find that public policy rendered the preferential transfers uninsurable under state law. The court recognized that because liability in a fraudulent transfer action is strict, without regard to fault, “allowing the insured to collect under its insurance policy would not encourage others to intentionally engage in unlawful activity with the purpose of reaping a benefit from such activity through its insurance.” Id. at 23. The court observed that the insurance company already had a safeguard in place to prevent the insureds from reaping a windfall, namely, the Illegal Profit Exclusion. Id. Thus the court properly refused to second guess an expressly stated term of the policy based on public policy arguments. 

 

In light of the J.P. Morgan ruling, insurers and insureds alike are well advised to take a fresh look at their policy wordings. The expanding use of the restitution defense, and the inherent difficulty in applying policy language to contractual terms such as restitution and disgorgement, strongly suggest that policyholders should demand clearer policy language. On the negative side, a few policies now expressly exclude restitution and disgorgement from the definition of Loss, without defining those terms. Some policies are silent and some exclude from Loss any damages that are uninsurable as a matter of state law. From a policyholder’s standpoint, it makes good sense to insist on coverage for restitution/disgorgement to the fullest extent insurable under the law, absent final adjudication that the disgorgement was to remedy illegal profit or criminal conduct. Even in the unlikely event that a state’s “public policy” would prohibit enforcement of such contracts, an insurer can surely stipulate in its policy that it will not assert that restitutionary damages are uninsurable unless there is a final adjudication of illegal profit or conduct. It is already widely accepted wording in almost every D&O policy (usually in the definition of “Loss”) that the insurer will not assert that (restitutionary) damages imposed under Sections 11 or 13 of the Securities Act are uninsurable as a matter of law; so this recommendation is in no way a “stretch.” Given the decade of litigation over these issues, for insurers to continue to assert this phantom exclusion instead of setting forth a clear statement in their policies is the real violation of public policy.

 

© Peter M. Gillon 2013

nystateAn insurer that breached its duty to defend may not later rely on policy exclusions to escape its duty to indemnify the insured for a judgment against him, according to a June 11, 2013 decision from the New York Court of Appeals. The Court of Appeals opinion can be found here.

 

A legal malpractice insurer had disclaimed a defense duty under its policy and a default judgment was entered against its insured. When the judgment creditor sought to enforce the judgment against the insurer, the insurer asserted coverage defenses based on policy exclusions other than it asserted in disclaiming its defense duty. The Court of Appeals ruled that the insurer that had denied its duty to defend could litigate only the validity of its disclaimer and could not rely on other policy exclusions to dispute its indemnification obligations.

 

Background

Goldan, LLC borrowed $2.83 million from two other companies. The loans were to be secured by mortgages. Goldan defaulted on the loans. The lenders then learned that the mortgages had not been recorded. The lenders sued Goldan and two of its principles, Mark Goldman and Jeffrey Daniels. The plaintiffs asserted a claim against Daniels for legal malpractice, alleging that Daniels had acted as the plaintiffs’ attorney with respect to the loan and that his failure to record the mortgages was “a departure from good and accepted legal practice.”

 

Daniels notified his legal malpractice carrier of the claim, which refused to provide either a defense or indemnity, stating that the allegations against Daniels “are not based on the rendering or failing to render legal services for others.”

 

The plaintiffs made a $450,000 settlement demand on Daniels (an amount well below the malpractice policy’s $2 million policy limit), which Daniels transmitted to the insurer. The insurer rejected the demand on the same ground on which it had denied coverage. Daniels then defaulted on the underlying claim and the plaintiffs obtained a default judgment against him in excess of the policy limit. Daniels assigned his rights under the malpractice policy to the plaintiffs, who then filed suit against the insurer for breach of contract and bad faith.

 

The insurer moved for summary judgment in reliance on two policy exclusions, the “insured’s status” exclusion (which precludes coverage for claims against an insured in his capacity as an officer, director or employee of a business enterprise) and on the “business enterprise” exclusion (precluding coverage for claims based on acts or omissions by any insured for any business enterprise in which the insured has a controlling interest). The plaintiffs cross-moved for summary judgment.

 

The trial court granted summary judgment for the plaintiffs on the breach of contract action, but granted the insurer’s motion for summary judgment on the bad faith claim. The intermediate court affirmed both rulings; the appellate court affirmed the breach of contract ruling on the grounds that the policy exclusions on which the insurer sought to rely were inapplicable. Two intermediate appellate judges dissented, arguing that there was an issue of fact whether the exclusions applied. The parties cross-appealed.

 

The June 11 Opinion

In a ten-page opinion written by Judge Robert S. Smith for a unanimous court, the Court of Appeals affirmed as to both claims, although with respect to the breach of contract issue, the Court of Appeals affirmed on different grounds than relied upon by the intermediate appellate court. The Court of Appeals did not reach the question of whether or not the exclusions on which the insurer relied precluded coverage here. Instead, the Court of Appeals held that when a liability insurer has breached its duty to defend its insured, the insurer may not later rely on policy exclusions to escape its duty to indemnify the insured for a judgment against him.

 

The Court of Appeals first confirmed that the insurer had a duty to defend the underlying claim. The Court of Appeals noted that the plaintiffs’ claim against Daniels “unmistakably pleads a claim for legal malpractice.” The allegations that Daniels had acted as the plaintiffs’ lawyers in the loan transaction were “unusual” and may even have been “groundless,” but that “does not allow” the insurer “to escape its duty to defend.” It might have been different “if the claim were collusive,” but the insurer did not assert collusion.

 

The Court then went on to hold that, having breached its duty to defend, the insurer could not rely on other grounds to contest a duty to indemnify its insured. The Court said that “an insurance company that has disclaimed its duty to defend may litigate only the validity of its disclaimer.” If, the Court said, “the disclaimer is found bad, the insurance company must indemnify its insured for the resulting judgment, even if policy exclusions would otherwise have negated the duty to indemnify.”

 

The Court justified this rule by saying that it “will give insurers an incentive to defend the cases they are bound by law to defend, and thus to give insureds the full benefit of their bargain.” The Court added that “it would be unfair to insureds, and would promote unnecessary and wasteful litigation, if an insurer, having wrongfully abandoned its insured’s defense, could then require the insured to litigate the effect of policy exclusions on the duty to indemnify.”

 

The Court did allow that “perhaps there are exceptions” to this rule. The Court noted that perhaps an insurer should not be barred from asserting that its insured injured the plaintiff intentionally. However, the Court noted, “no such public policy argument is available to [the insurer[ here.” Here, the insurer “having chosen to breach its duty to defend, cannot rely on policy exclusions to escape its duty to indemnify.”

 

Finally, the Court affirmed the lower court’s dismissal of the plaintiffs’ bad faith claims. Although the plaintiffs alleged that the insurer had failed to settle the underlying claim, the Court of Appeals noted that their claim was really not for a bad faith failure to settle, but for a bad faith failure to defend. The Court of Appeals said that “we need not decide …whether such an allegation could ever support a claim for damages in excess of the policy limit,” as “such a claim would require the insured to show, at a minimum, that the judgment against him would not have been entered if the insurer had defended the case,” which had not been alleged here.

 

Discussion

At the heart of the Court of Appeals decision seems to be a view that this insurer should have defended its insured.  The Court of Appeals clearly did not even consider the defense duty to be a close question. The underlying claims may have been both odd and groundless, but the insurer still had the obligation to defend its insured. (Not only that, but it seems pretty clear that the insurer would have been way better off if it had just defended its insured.) 

 

At first blush, this seems like a very adverse decision for insurers. But closer review suggests a reading that is a little less threatening for the insurers. One possible message from the Court of Appeals ruling is that this insurer was simply too terse when it denied it had an obligation to defend; it does seem that if the insurer had cited all of the alternative grounds on which it eventually sought to rely, it would have been able to rely on those grounds in contesting coverage. Certainly, going forward, any insurer denying the duty to defend under a liability insurance contract to which New York law applies will want to comprehensively state the basis on which it is denying a defense duty.

 

On the other hand, even if the insurer here had provided a more comprehensive basis for its rejection of the duty to defend, and thus preserved its right to rely on the two policy exclusions, it likely wouldn’t have helped the insurer in the end. A majority of the judges at the intermediate appellate court – the only court to consider the applicability of the exclusions on which the insurer sought to rely – concluded that the exclusions did not apply. Even though two judges dissented, the message seems to be that the insurer lacked a basis to disclaim a duty to defend. And so, again, the main message from this case seems to be that insurers should be very wary of disclaiming the duty to defend (rather than any arguable alternative message about taking greater care and being more comprehensive when disclaiming a defense duty).

 

Even if insurers consider the rule the Court of Appeals enunciated here to be harsh, the Court did provide one (small) escape hatch. The Court did acknowledge that there could be public policy exceptions to the preclusive rule it defined in this case. How broad this public policy exception might prove to be is unclear. However, I suspect there will be a host of cases in the future in which this exception will be better defined.

 

In a June 13, 2013 post on its Insurance Law Blog (here), a memo from the Traut Lieberman law firm states that the Court of Appeals decision “announced a new rule,” and that previously “New York courts at both the state and federal level consistently rejected the notion that by having breached a duty to defend, an insurer is estopped from relying on coverage defenses for the purposes of contesting an indemnity obligation.” The Court of Appeals decision “departs from this long-established jurisprudence.”

 

FDIC Launches Another Failed Bank Lawsuit: On June 10, 2013, the FDIC as receiver for the failed Sun American Bank of Boca Raton, Florida, filed a lawsuit in the Southern District of Florida against seven former directors and officer of the bank. The FDIC’s complaint can be found here. The bank failed on March 5, 2010, well over three years ago, suggesting that the parties had previously reached some type of tolling agreement. The FDIC asserts claims against the defendants for negligence and gross negligence. The FDIC alleges that the defendants failed to use safe and sound banking practices and failed to adhere to prudent underwriting practices in approving a total of seven loans.

 

According to news reports about the FDIC’s lawsuit against the former bank directors and officers, this latest suit represents the seventh that the agency has filed in connection with a failed Florida bank. The FDIC has now filed a total of 66 lawsuits against former directors and officers of banks that failed during the current bank failure wave, including 22 so far during 2013.

 

Is it possible that we seen the last of “Say-On-Pay” lawsuits? Or are we just awaiting the next round of post-Dodd Frank executive compensation-related litigation? Those are the questions asked in a June 12, 2013 memorandum entitled “Has Another Wave of ‘Say-On-Pay’ Litigation Come to an End?” (here) by Nicholas Even of the Haynes and Boone law firm. Whatever may lie ahead, the latest round of Say-On-Pay litigation seems to have come to a close.

 

First, a little background. One of the changes introduced in Dodd-Frank’s many provisions was a requirement that reporting companies hold a periodic shareholder vote on executive compensation. Even though the vote was, by the Act’s terms, to be purely advisory, and even though the Act expressly stated that the shareholder vote “may not be construed” to “create or imply any change to the fiduciary duties of such issuer or board of directors” or to “create or imply any additional fiduciary duties for such issuer or board of directors,” shareholder plaintiffs (and their attorneys) sought to pursue breach of fiduciary duty lawsuits against companies whose shareholder votes resulted in a “no” vote on executive compensation issues.

 

These “first wave” say-on-pay lawsuits, mostly filed in 2011, proved to be unsuccessful. So in 2012, the shareholder plaintiffs tried a different approach. Borrowing a page from the M&A-related litigation play book, the shareholder plaintiffs (largely represented by a single law firm) filed lawsuits seeking to enjoin the annual meeting unless the company made additional compensation related disclosures. Ultimately, more than 20 of these “new wave’ say on pay lawsuits were filed.

 

The second wave of say on pay lawsuits proved largely unsuccessful as well. As outlined in the law firm’s memo, there were two injunctions issued and those cases were quickly settled. Several other companies chose to settle by issuing supplemental disclosures. Generally, in the other cases, the courts denied the injunctive relief and/or dismissed the cases. (Refer here for further discussion of these issues.)

 

As the 2013 proxy season began, there was significant concern that there would be further waves of executive compensation-related litigation. As the law firm memo notes, a number of companies were put on notice that they were under “investigation” over compensation related issues. But a funny thing has happened. According to the law firm memo, “no injunctive lawsuits materialized, either challenging the say-on-pay or equity incentive plans.”  Specifically, “no companies appear to have been targeted for say-on-pay injunctive suits in advance of annual meetings during the 2013 proxy season.”

 

The law firm memo’s author speculates that the reason for the absence of litigation could be that “the attorneys previously responsible for these suits have simply turned their attention to different issues or have become distracted with other matters.” It could also be that after the many denials of injunctive relief in the 2012 say-on-pay cases, the plaintiffs’ counsel “discovered that the threat of injunctive action has lost its in terrorem effect.”

 

Whatever the reason, the “latest attempt to refashion Dodd-Frank’s say on pay requirement into an annual litigation phenomenon appears to have waned.” Nevertheless, even if the immediate injunctive threat has “diminished,” it remains that “the combination of Dodd-Frank, executive compensation, and annual meetings remains fertile ground for potential shareholder action.” The law firm memo’s author concludes with the question whether “a ‘third wave’ of say-on-pay litigation” is “inevitable?”

 

Among its many provisions, the Dodd-Frank created a new Federal Insurance Office within the U.S. Department of Treasury. The Act requires the FIO’s Director to provide a report each year to the President and to Congress “on the insurance industry and any other information deemed relevant by the Director or requested [by a Congressional] Committee.” The initial report was due in January 2012; like many of the regulatory actions required under the Dodd-Frank Act, the initial report was delayed. However, on June 12, 2013, the FIO finally released its first report, which can be found here. The Treasury Department’s June 12, 2013 press release about the report can be found here.

 

Though the report weighs in at a slim 53 pages (including endnotes), the report covers a lot of ground. It not only provides a financial overview of the U.S. insurance industry, but it also reviews, from the perspective of the U.S. insurance industry, the efforts that have been undertaken in the wake of the financial crisis to try to improve financial stability.

 

Among other things, the report notes that the U.S. insurance industry’s aggregate 2012  premiums totaled more than $1.1 trillion, or about 7 percent of U.S. gross domestic product. The industry directly employs 2.3 million people or 1.7 percent of the country’s nonfarm payrolls. (Those employment figures do not include the additional 2.3 million licensed insurance agents and brokers). The U.S. insurance industry also reports total assets of $7.3 trillion, of which $6.8 trillion represents invested assets.

 

The industry has shown recovery and improvement since the financial crisis. Both the Life and Health and the Property and Casualty sectors reported improved profitability in 2012. Moreover, at year-end 2012, reported surplus levels were at record highs for both the Life and Health and for the Property and Casualty sectors. At year end, the Life & Health sector reported surplus of about $329 billion and the Property and Casualty Sector reported surplus of about $597 billion.

 

Amidst all of these positive developments there are also some challenges – particularly the interest rate environment and the level of natural catastrophes.

 

 As the report notes, “despite near record net investment income in 2012, insurers’ investment yields remained low as a percentage of invested assets.” The low interest rates pose a “challenge for insurers seeking to balance investment risk and return.” The low interest rate environment poses a particular challenge for life insurers offering annuities with guaranteed benefits. The low interest rates also affects the present value of insurer contract obligations, particularly those of life insurers; as interest rates have decreased, the present value of future obligations have increased.

 

But though increased interest rates would produce improved investment returns, a sudden increase would involve other threats. Were interest rates to increase suddenly, interest rate levels would increase unrealized losses in insurer fixed income portfolios and could also prompt policyholders of interest bearing contracts to surrender the contracts for higher yield elsewhere.

 

Natural catastrophes also continue to pose a significant challenge to insurers. 2011 was the second costliest year on record for natural catastrophes in the United States, with insured losses estimated to be about $44.2 billion (the most significant losses were during 2005, the year of Hurricane Katrina and other hurricanes). The estimate for catastrophic losses during 2012 is about $43 billion, only slightly below 2011.

 

The body of the report contains several other items of interest, including several tables listing the largest insurers (by premium volume) within various industry sectors. The report also includes detailed financial information divided by sector, including aggregate information on the various sectors’ annual underwriting results. Among other things, the underwriting results information shows that during the catastrophe-driven years of 2011 and 2012, the Property and Casualty sector experienced underwriting losses. (The P&C industry combined ratio for 2011 was 108.3 and for 2012 was 103.3.)

 

My own observation about the interest rate environment is that it is directly affecting insurers’ underwriting behavior. Ordinarily, the expectation at a time when insurers are reporting record levels of surplus would be that there would be a great deal of competition in the marketplace, particularly on price. However, because the low interest rate environment means that investment income is under pressure, the insurers are forced to try to make their calendar year profitability from their underwriting operations. In order to try to produce an underwriting profit, the insurers are under pressure to try to increase pricing. The end result for insurance buyers is that they are facing pricing increases – particularly in the commercial insurance arena, where catastrophic losses in the P&C sector have meant consecutive years of underwriting losses.  

 

Natural catastrophes have been part of life throughout history. But as insured values increase and possibly as climate change produces more extreme weather events, the human (and therefore the insurance) impact from catastrophes has increased. It is far too early to tell how this year will turn out from a catastrophe perspective, but with the recent tornadoes in Oklahoma and with the Hurricane season just underway, we all have reason to be watchful and wary.

 

More About Insurance Coverage for Cyber Breaches: In a recent two-part series, Roberta D. Anderson of the K&L Gates law firm reviews the availability of insurance coverage to protect against losses arising from cyber breaches. The two installments can be found here and here.

 

The first installment provides background regarding the exposure and reviews the limitations associated with trying to obtain insurance coverage for cyber breaches under Commercial General Liability policies. The second installment goes on to discuss the limitations associated with trying to obtain insurance coverage for cyber breaches under property policies and other traditional insurance policies. The second installment then goes on to discuss the advent and development of purpose built cyber policies in the insurance marketplace. The article describes the first-party and third-party protection available under the cyber policies and the specific ways that the policies are designed to respond to various types of cyber incidents. The article reviews and compares various policies’ specific terms and conditions.

 

The two articles provide a quick but comprehensive overview of this emerging area of liability and insurance.

 

In a June 11, 2013 opinion, the New York Court of Appeals held that Bear Stearns is not barred from seeking insurance coverage for a $160 million portion of an SEC enforcement action settlement labeled as “disgorgement,” where Bear Stearns’ customers rather than Bear Stearns itself profited from alleged misconduct.  The Court’s opinion reversed the ruling of an intermediate appellate court which had held that Bear Stearns could not seek insurance coverage for the settlement amount labeled as “disgorgement.” The opinion of the Court of Appeals can be found here.

 

Background

In 2006, the SEC notified Bear Stearns that the agency was investigating late trading and market timing activities units of Bear Stearns had undertaken for the benefit of clients of the company. The agency advised the company that it intended to seek injunctive relief and monetary sanctions of $720 million.

 

Bear Stearns ultimately made an offer of settlement and –without admitting or denying the agency “findings” – consented to the SEC’s entry of an Administrative Order, in which, among other things, Bear Stearns agree to pay a total of $215 million, of which $160 million was labeled “disgorgement” and $90 million as a penalty.

 

At the relevant time, Bear maintained a program of insurance that, according to the subsequent complaint, totaled $200 million. Bear Stearns sought to have the carriers in the program indemnify the company for the SEC settlement. However, the carriers claimed that because the $160 million payment was labeled “disgorgement” in the Administrative Order, it did not represent a covered loss under the insurance policies.

 

In 2009, J.P. Morgan (into which Bear Stearns merged in 2008) filed an action seeking a judicial declaration that the insurers were obliged to indemnify the company for the amount of the $160 million payment in excess of the $10 million self insured retention. The company argued that notwithstanding the Administrative Order’s reference to the amount as “disgorgement,” its payment to resolve the SEC investigation constituted compensatory damages and therefore represented a covered loss under the insurance program. The carriers moved to dismiss the company’s declaratory judgment action.

 

In a September 14, 2010 order (here), New York (New York County) Supreme Court Charles E. Ramos denied the carriers’ motion to dismiss. He held that the Administrative Order’s use of the term “disgorgement” did not conclusively establish that the settlement amounts were precluded from coverage.

 

In reaching this conclusion, he noted that the Administrative Order “does not contain an explicit finding that Bear Stearns directly obtained ill-gotten gains or profited by facilitating these trading practices,” and he found that the provision of the Order alone “do not establish as a matter of law that Bear Stearns seeks coverage for losses that include the disgorgement of improperly acquired funds." Judge Ramos rejected the insurers’ argument that they were entitled to dismissal.

 

As discussed here, in a December 13, 2011 opinion (here), the N.Y. Supreme Court, Appellate Division, First Department, reversed the lower court’s holding, granted the motions to dismiss and directed the entry of judgment in favor of the insurers. The appellate court concluded that the “SEC Order required disgorgement of funds gained through that illegal activity,” and that “the fact that the SEC did not itemize how it reached the agreed upon disgorgement figure does not raise an issue as to whether the disgorgement payment was in fact compensatory.”

 

The intermediate appellate court  further noted that in generating revenue of at least $16.9 million, “Bear Stearns knowingly and affirmatively facilitated an illegal scheme which generated hundreds of millions of dollars for collaborating parties and agreed to disgorge $160,000,000 in its offer of settlement.”  Bear Stearns appealed the intermediate appellate court’s ruling.

 

The June 11 Court of Appeals Decision

In a June 11 opinion written by Judge Victoria Graffeo for a unanimous court, the Court of Appeals reversed the intermediate appellate court and reinstated Bear Stearns’  complaint.

 

The insurers had argued that coverage for the “disgorgement” amount was precluded on two different coverage ground; first, that public policy prohibits insurance when an insured has engaged in conduct “with the intent to cause injury;” and second, that public policy prohibits insurance for disgorgement amounts.

 

The Court of Appeals first rejected the intentional injury argument, holding that though the SEC’s order recited that Bear Stearns has willfully violated federal securities laws, the Court of Appeals could not conclude that the public policy coverage preclusion applied. The SEC order, “while undoubtedly finding Bear Stearns’ numerous securities law violations to be willful, does not conclusively demonstrate that Bear Stearns also had the requisite intent to case harm.”

 

The Court of Appeals also rejected the insurers’ argument that public policy prohibits insurance for the “disgorgement” amounts. The Court of Appeals found that the SEC Order “does not establish that the $160 disgorgement payment was predicated on moneys that Bear Stearns itself improperly earned.” Rather, the order recites that Bear Stearns’ misconduct allowed its customers to profit.

 

The Court of Appeals found that the cases on which the insurers sought to rely in arguing that insurance coverage is precluded for disgorgement amounts linked the disgorgement payment to improperly acquired funds in the hands of the insured. The cases, the Court of Appeals said, “directly implicated the public policy rationale for precluding indemnity – to prevent the unjust enrichment of the insured by allowing it to, in effect retain the ill-gotten gains by transferring the loss to its carrier.” In this case, the Court said, “Bear Stearns alleges that it is not pursuing recoupment for the turnover of its own improperly acquired profits and, therefore, it would not be unjustly enriched by securing indemnity.”

 

The carriers, the Court of Appeals said, had not identified a single case where coverage was prohibited when the disgorgement payment was, at least according to Bear Stearns’ allegations, linked to gains that went to others.

 

The Court of Appeals also rejected the insurers’ argument that the improper profit exclusion precluded coverage for Bear Stearns’ claims. The Court said that because Bear Stearns alleged that its misconduct profited others, not itself, “the exclusion does not defeat coverage.”

 

Discussion

Bear Stearns faced an uphill battle trying to argue, that a portion of the SEC settlement expressly labeled as “disgorgement” is not precluded from coverage based on case law establishing that public policy bars insurance coverage for “disgorgement” amounts.

 

Nevertheless, Bear Stearns was able to successfully argue that because at least $140 million of the disgorgement amount represented its customers’ profits, not its own, the company was not seeking to retain its own ill-gotten gains. The Court of Appeals observation that the insurers were unable to cite a single case in which coverage had been precluded under these kinds of circumstances is interesting.

 

The Court of Appeal’s holding suggests that there may be circumstances in which an insured might seek insurance coverage for an amount labeled as “disgorgement,” at least where the insured itself did not profit from the improper conduct that was the basis of the disgorgement. However, this holding is only going to be useful for insured’s seeking coverage in a limited range of circumstances. The Court of Appeals opinion will be of no help to insureds seeking coverage for “disgorgement” under the more typical circumstances where the insured is alleged to have profited from the wrongful conduct that was the basis of the disgorgement.

 

Nevertheless, the Court of Appeals decision does provide at least one example where an insured was permitted to seek insurance coverage for amounts labeled as a “disgorgement.”  Insureds will undoubtedly seek to rely on this decision when trying to seek insurance coverage for disgorgement amounts and insurers undoubtedly will argue that the insured’s claim does not involved the kind of circumstances presented here.

 

It probably should be noted that the Court of Appeals did not rule that the insurers’ policies covered the disgorgement amount. The Court of Appeals held only that Bear Stearns was not, based on the allegations in its complaint, precluded from seeking insurance coverage. The parties must now return to the trial court, where there will be further proceedings to determine whether or not there is coverage under the policies for the “disgorgement” amount.

 

A June 11, 2013 Memorandum by the Troutman Sanders law firm discussing the Court of Appeals decision can be found here.

 

The bankruptcy context is particularly ripe for D&O claims, and it also represents a particularly difficult claims context for D&O insurers. Anyone with any doubts about just how complicated bankruptcy claims can be will want to take a look at the settlement that the various concerned parties recently reached in the bankruptcy of defunct Florida homebuilder, TOUSA, Inc.

 

As discussed below, various D&O insurers will be paying a total of $67 million to settle claims that had been asserted against former directors and officers of TOUSA and related entities. According to the motion papers, the settlement agreement is part of a “grand bargain” to resolve claims among the various parties in adversary proceedings filed in the bankruptcy matter, as a part of larger efforts to facilitate the entry of a liquidation plan for the TOUSA bankruptcy estate. The parties’ June 4, 2013 settlement agreement can be found here. The parties’ June 6, 2013 motion for court approval of the settlement can be found here.

 

The $67 million aggregate settlement amount does not include additional funds that will be contributed by at least one other D&O insurer that reportedly will be entering a separate settlement agreement, and also does reflect an additional $8.5 million that two of the insurers involved have agreed to pay toward incurred but as yet unpaid defense expenses. One of TOUSA’s D&O insurers declined to participate in the settlement, and the settlement contemplates an assignment to the bankruptcy estate and to secured lenders committee of the debtors’ and the insured persons’ rights against the non-settling insurer. The settlement agreement is subject to bankruptcy court approval.

 

Background

On January 29, 2008, TOUSA and related entities filed a voluntary bankruptcy petition in the Southern District of Florida. In the years prior to the bankruptcy, related TOUSA entities had entered into a joint venture known as Transeastern JV to acquire another Florida homebuilder. In connection with the JV various TOUSA entities entered into certain debt financing agreements. The joint venture later failed.

 

On June 14, 2008, the unsecured creditors committee filed an adversary proceeding in the bankruptcy matter against a total of 19 former directors and officers of TOUSA and related entities. The committee alleged that the defendants had breached their fiduciary duties by failing to act in the best interests of the various TOUSA corporate entities and of the entities’ constituencies, including the creditors, and that certain of the defendant aided and abetted these breaches. During the course of ensuing proceedings, the individual defendants filed a total of six motions to dismiss the fiduciary duty claims, each of which was denied by the bankruptcy court.

 

The debtors and the individual defendants submitted the fiduciary duty matter as a claim to TOUSA’s D&O insurers. Certain of the insurers denied coverage for the claim. The debtors and the individuals filed an insurance coverage action as an adversary proceeding  in the bankruptcy matter seeking a judicial declaration of coverage  After the coverage action was commenced, the parties entered into an interim funding agreement that allowed for the payment of the defense fees of the individual defendants in the fiduciary duty action.

 

In addition, in December 2009 certain of the lenders involved in financing the failed Transeastern JV sent demand letters to the debtors and to the individual directors and officers asserting claims against them in connection with the various JV lending transactions. The debtors submitted these demands as claims to TOUSA’s D&O insurance carriers, for which several of the D&O insurers denied coverage.

 

In August 2010, the court ordered the parties to mediation. The list of participants in the mediation is long; it includes various creditors committees, the various debtor entities, the various entities that were involved in proving the joint financing of the failed JV, the individual defendants themselves, and as many as 12 D&O insurers.

 

The Settlement Agreement

It is some measure of the complexity of this matter and the number of moving parts that the mediation commenced in August 2010 only finally resulted in a settlement that could be submitted to the court in June 2013.

 

A total of ten of TOUSA’s D&O insurers participated in the settlement agreement submitted to the court. The ten participating insurers (and their respective contributions to the $67 million settlement and also toward additional defense expenses) are listed on page 11 of the settlement agreement. An eleventh insurer (apparently from Bermuda) reportedly will be entering a separate agreement in an amount that is not specified in the motion papers. A twelfth insurer (identified in footnote 1 on page 3 of the settlement agreement) declined to participate in the settlement, and one feature of the settlement is the debtors’ and the individual defendants’ assignment of their rights against this one non-settling insurer.

 

The list of the various parties and participants to this “grand bargain” settlement consumes more than two pages of the settlement agreement. As might be expected with a list of participants that long, the settlement agreement is complicated. As explained on page 9 of the motion for approval of the settlement, the $67 million settlement amount will be divided, with almost $48 million going to the unsecured creditors in connection with the breach of fiduciary duty claims; and a total of about $19 milliongoing to the various JV lenders, with this amount to be further divided among the lenders in differing amounts according to their respective interests. Presumably the separate settlement agreement with the Bermuda insurer will contribute additional amounts toward these various settlement funds.

 

Discussion

The settlement documents does not detail how TOUSA’s D&O insurance program was arranged, but the D&O insurers’ varying payment amounts specified in the settlement agreement suggests that the insurance was arranged as a tower and that the various insurers contributed toward the settlement according to their respective attachment point in the tower, with each succeeding insurer in the tower contributing a correspondingly smaller amount.

 

It is not clear from the settlement papers, but it appears that the insurance programs from more than one policy year may have been implicated here  (for example, the description of the complications involved with defense counsel payments suggests that there was a dispute between at least two carriers that might have been the primary carriers). Obviously, the involvement of more than one insurance tower and questions whether only one or both of the towers had been triggered represented a further complicating factor in trying to reach a settlement agreement.

 

Given the bankruptcy context, it seems probable that the insurance was funded as a loss under the D&O insurance policies’ Side A coverage (providing coverage for amounts that are not indemnified, whether due to insolvency or legal prohibition). This detail may have been relatively unimportant to the various “traditional” D&O insurers. But to the extent that any of the excess D&O insurers were providing only excess Side A insurance (or Excess Side A/DIC) insurance, this is a very important distinction, because if these losses were not Side A losses the Excess Side A insurers’ coverage would not have been triggered. From outward appearances (and it is always hard tell from the outside) at least some of the contributing D&O insurers were Excess Side A insurers. If that is the case, then this represents yet another recent example where the Excess Side A limits have been called upon to contribute toward a major D&O loss.

 

I can only imagine how difficult it was for the various parties to reach a settlement understanding in this case.Actually, that isn’t quite right – I really can’t imagine how they reached a settlement understanding.

 

With all of the competing claimants and the varying and competing interests, and the various insurers – many of them disputing whether there coverage was even involved owing to questions whether more than one tower of insurance was involved – trying come up with a framework for settlement, figuring out how much each insurer would contribute, and then deciding how the various contributions would be divided among the various claimants, had to have been an absolute nightmare. Just to add to the mix, there were further complications owing to the Bermuda insurer and to the one remaining excess insurer that declined to participate in the settlement. And throughout all of this, defense costs that would erode the amount of limits remaining for settlement were being incurred.

 

There is probably much more besides that could be said about this settlement, particularly by someone with an inside perspective (and I encourage anyone with a perspective on this settlement to add their comments to this post, using this blog’s comment feature if possible and posting anonymously if necessary).

 

The one last thing I will say is that this massive settlement is yet another example of a jumbo D&O settlement outside of the context of securities class action litigation. As I have noted numerous times in recent years on this site, the mix of corporate and securities litigation is changing, and while securities class action litigation remains important, it is now one of multiple sources of significant corporate and securities litigation. Increasingly, these other types of corporate and securities lawsuits are contributing significantly to the severity of losses in this arena. The number of jumbo D&O settlements that do not involve securities class action litigation continues to grow.

 

Typically, the FDIC updates the professional liability lawsuits page about once a month, but on June 7, 2013, only about two weeks after its last update, the FDIC again updated the page to include new lawsuit information. According to the information in the latest update, the FDIC has now filed a total of 65 lawsuits against the directors and officers of failed banks as part of the current bank failure wave, including a total of 21 new lawsuits during 2013.

 

In the FDIC’s most recent update, the agency including information about its two most recently filed lawsuits. The FDIC filed the first of these two lawsuits on May 24, 2013 in the District of Nevada, in the agency’s capacity as receiver for the failed Sun West Bank of Las Vegas, Nevada. The bank failed on May 28, 2010, meaning that the agency filed its lawsuit just before the third anniversary of the bank’s closure. As reflected in the agency’s complaint (here), the FDIC as receiver for the failed bank has named nine of the bank’s former officers and directors as defendants, asserting claims against them for gross negligence and for breaches of fiduciary duties. The agency alleges that each of the defendants approved “certain high risk loans in violation of the Bank’s existing loan policies and prudent lending practices.” The agency seeks to recover “damages in excess of $8 million” that it claims the defendants’ misconduct caused.

 

Interestingly, the individual defendants not only served as bank directors and officers, but they also each had substantial ownership interests in the Bank’s holding company. Collectively, the individual defendants allegedly owned or controlled 59.3 percent of the holding company’s stock.

 

The FDIC filed the second of its two latest lawsuits on May 31, 2013. The agency filed the action in the District of Nebraska against eight former directors and officers of the failed TierOne Bank of Lincoln, Nebraska. The bank failed on June 4, 2010 in what was, according to press reports, the largest bank failure ever in Nebraska. The agency filed its lawsuit just before the third anniversary of the bank’s failure. The FDIC’s complaint, which can be found here, asserts claims against the defendants for gross negligence and for breach of fiduciary duty for approving “eight poorly underwritten acquisition, development and construction loans from April 21, 2006 through September 17, 2008.” The complaint alleges that the defendants’ ignored the bank’s own loan policies and prudent banking practices in approving “risky” loans in Las Vegas.

 

There are a couple of interesting things about these two lawsuits. The first is that both of the complaints assert claims only for gross negligence and for breaches of fiduciary duties. Many of the other D&O lawsuits the FDIC has filed have not only asserted these claims but also asserted claims for negligence as well. Much of the early skirmishing in the lawsuits involving negligence allegations involves motions filed by the individual defendants in those cases asserting that mere claims of negligence are not sufficient to hold them liable. In these two latest cases, by contrast, the FDIC has sidestepped this issue entirely, seeking recovery only for claims of gross negligence and for breach of fiduciary duty.

 

The other thing about these cases is that they both are based primarily on loans made in the deteriorating Las Vegas real estate market five or more years ago. The collapse of the Las Vegas real estate market, as well as the collapse of other regional real estate markets that had surged during the boom years last decade, contributed to the closure of many banks. Although the agency’s filing of these lawsuits apparently met the strict requirements of the statute of limitations, there does seem to be a sense in which the agency’s lawsuits increasingly involve stale allegations. As time goes by, questions about loans made into the real estate bubble a long time seem increasingly pointless. The events from that time are starting to seem like ancient history.

 

Though the FDIC updated its professional liability lawsuits page to add these two latest lawsuits, the agency did not update the information about the number of authorized lawsuits. The number of authorized lawsuits remains unchanged from the May update; the agency has authorized suits in connection with 114 failed institutions against 921 individuals for D&O liability. With the addition of the two latest lawsuits, the agency has 65 filed D&O lawsuits naming 505 former directors and officers as defendants. The implication is that there are as many 49 yet-to-be-filed lawsuits in the pipeline.

 

Even though the current bank failure wave is now well into its sixth year, banks continue to fail. As reflected on the agency’s failed bank list, the agency closed two more banks last week, the 1st Commerce Bank of North Las Vegas, Nevada (which the agency closed in an unusual Thursday night closure on June 6, 2013) and Mountain National Bank of Sevierville, Tennessee, which the agency close in a more conventional Friday night closure on June 7, 2013. These two latest closures bring the total number of bank failures so far this year to 16 (compared to 51 in all of 2012), and the total since January 1, 2007 to 484.

 

Unfortunately, despite the gradual economic recovery, bank failures may continue. As noted here, in the FDIC’s most recent Quarterly Banking Profile, the agency reported that it still continues to rate 8.7% of the depositary institutions as “problem institutions,” and though both the number and percentage of problem institutions has declined, the number of problem institutions remains stubbornly high.