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The Continuing Struggle For D&O Coverage
Law360, New York (November 29, 2010) -- In the current financial turmoil and turbulence, directors and officers must feel as though they have targets on their backs. Whether as the result of a collapsed Ponzi scheme or of a creative creditors' committee, suits against directors and officers abound. When sued, these individuals frequently turn to their directors and
- fficers liability policies for protection. Unfortunately, insurers, in reply, often turn their backs
- n their insureds.
As a general rule, D&O policies provide much less coverage than policyholders expect. A constant tension exists between the efforts of brokers and consultants to enhance coverage and the insurers' efforts to narrow it. Moreover, the liability of directors and officers is constantly changing. As a result, the D&O insurance world is in a constant state of flux, and insurers are quick to find novel arguments to deny coverage. The cases discussed below demonstrate that policyholders must be vigilant in protecting their insurance rights. Money Laundering Exclusions: Faced with the fallout from the Stanford Ponzi scandal, the U.S. District Court for the Southern District of Texas barred coverage for three directors and
- fficers of the Stanford Financial Group entities (collectively, “the Group”) where they “knew,
suspected or reasonably should have known or suspected” that the Group’s (i) financial records contained fictitious or unsubstantiated information and (ii) reports to the holders and prospective purchasers of certificates of deposit (“CD”) contained misrepresentations and
- missions regarding the Group’s financial condition. Pendergest-Holt v. Certain Underwriters
at Lloyd’s of London, et al., No. 09-3712, U.S. Dist. LEXIS 108920 (S.D. Tex. Oct. 13, 2010). In Pendergest-Holt, the plaintiffs — the sole owner of the Group and the chief accounting officer and controller of one of the Group’s entities — were accused of participating in a massive Ponzi scheme in which the Group allegedly defrauded CD holders of several billion dollars. Following the commencement of criminal and SEC actions related to the alleged fraud, the plaintiffs sought coverage from their insurers for defense costs under several D&O policies. Importantly, the policies contained exclusions for money laundering. The exclusions barred coverage if the insured engaged in certain acts with respect to “criminal property,” which is a benefit that the insured knew, suspected or reasonably should have known or suspected was obtained from criminal conduct. If money laundering occurred, the policies imposed an
- bligation on the insurers to pay defense costs “until such time that it is determined that the alleged act or acts did in fact
- ccur.” Policyholders should note that that this “in fact” standard is less favorable than a “final adjudication” standard.
Robert D. Chesler Danielle C. Carmona
SLIDE 2
Though the insurers initially agreed to pay defense costs, they later denied coverage retroactively back to August 27, 2009 — the date on which the Group’s chief financial officer entered into a plea agreement admitting participation in the scheme and falsification of documents. In denying coverage to the plaintiffs and seeking reimbursement, the insurers relied upon the money laundering exclusion. The plaintiffs sought and obtained a preliminary injunction ordering the insurers to advance defense costs, leading the insurers to appeal. The U.S. Court of Appeals for the Fifth Circuit affirmed the preliminary injunction, but remanded the case to the district court to render an “in fact” determination as to whether money laundering had occurred. On remand, the district court conducted the “in fact” determination as part of an evidentiary hearing for the injunction. In vacating the injunction, the district court found that the insurers had proven, by a preponderance of the evidence, that there was a substantial likelihood that the money laundering exclusion applied to the plaintiffs. This case highlights that insurers are constantly adding exclusions to D&O policies. (See discussion, infra, of “bump-up” exclusion.) Despite the use of brokers and consultants, policyholders need to be vigilant in reviewing their insurance policies and, in particular, the endorsements added by the insurer. The Duty to Defend: The U.S. Court of Appeals for the Ninth Circuit held that the former officer of a corporation was entitled to a defense under a D&O policy even though the underlying complaint did not specifically allege that he committed certain acts “in his capacity as” chief executive officer. Goerner v. Axis Reinsurance Co., 2010 U.S. App. LEXIS 21624 (9th Cir. Oct. 20, 2010). In Goerner, the Ninth Circuit recognized that, were it to bar coverage in this instance, the CEO “would not be owed a defense even for actions he was directly ordered by his superiors to undertake if the third-party plaintiff failed to allege in the complaint that those actions were undertaken in his capacity as CEO.” Such an outcome would not only “defeat the purpose of insurance coverage,” but would also be inconsistent with an insured’s reasonable expectation of coverage. Because the facts contained in the underlying complaint raised the “possibility of coverage,” the Ninth Circuit found that the insurer had a duty to defend the CEO under the policy. As Goerner illustrates, an insurer’s duties do not depend on the label that plaintiffs attach to their claims against the insured; rather, the insurer’s duties depend on how the facts of the underlying case relate to the insurance policy. If a complaint is ambiguous, courts will typically construe such ambiguities in favor of coverage and require the insurer to defend the suit. However, these rules of construction do not prevent insurers from contesting coverage. In Goerner, the district court ruled for the insurer, and the circuit court reversed. Settlement Agreements Relieving Insured of Obligation to Pay Judgment: In U.S. Bank National Association v. Federal Insurance Company, et al., No. 10-CV-0266-W-HFS, 2010 U.S. Dist. LEXIS 105553 (W.D. Mo. Oct. 4, 2010), the U.S. District Court for the Western District of Missouri held that an officer who had settled claims against him for a $56 million judgment suffered no “loss” under a D&O policy where the settlement agreement relieved him of his obligation to pay the judgment. Since such settlements are typical, this case is potentially of great concern. Policyholders can only hope that few courts will follow this reasoning. In U.S. Bank, the trustee of a creditor’s trust sued the former officer of the debtor-corporation in a fiduciary action seeking more than $100 million in damages. The officer sought and was denied coverage under the debtor’s D&O policies, but eventually settled his claims. As part of the settlement, the officer was promised that, upon assigning his coverage rights to the trustee, “he would not be pursued for payment.” As assignee, the trustee filed suit against the D&O insurers, which, in turn, moved to dismiss the action.
SLIDE 3 Granting the insurers’ motion to dismiss, the district court found that the policy precluded coverage. Because the policy covered only those sums that an insured became “‘legally obligated to pay’ and for which he has not been ‘absolved from payment,’” the officer could not have suffered a loss if he was “contractually exempted from collection of the judgment.” Thus, the Court found that the “crystal clear” language of the policy favored the insurers. Pursuant to U.S. Bank, settlement of an underlying action that includes an agreement to pursue only the D&O insurer and not the insured may now pose a significant risk to the assignee. Parties to such a settlement may need to seek the bankruptcy court's blessing beforehand. It may be possible to distinguish U.S. Bank because D&O policies do not typically contain the 'absolved from payment' language on which the court relied. SEC Investigations: In Office Depot Inc. v. National Union Fire Insurance Co. of Pittsburgh, Pa., et al., No. 09-80554-CIV- MARRA, 2010 WL 4065416 (S.D. Fla. Oct. 15, 2010), the U.S. District Court for the Southern District of Florida held that a corporation could not recover under it organization and executive liability insurance policy for attorneys' fees incurred in voluntarily responding to an SEC investigation or conducting an internal investigation and audit. In Office Depot, the corporation sought reimbursement of the $23 million it incurred to (i) respond to an SEC informal inquiry in which it voluntarily produced documents and made its employees and officers available for testimony, (ii) conduct an internal investigation and audit prompted by a whistleblower complaint regarding accounting irregularities, (iii) provide indemnification for defense costs for officers and directors who were served with SEC subpoenas and Wells Notices as part of a formal SEC investigation, (iv) defend various securities lawsuits and (v) settle with the SEC. Although the primary insurer acknowledged many of its indemnification obligations, it refused to reimburse the corporation for its voluntary response efforts and its internal investigation. Ruling in favor of the insurers, the district court found that the policy did not cover the SEC’s investigation because investigations of the corporation were expressly excluded from the definition of a “securities claim.” Although the policy contained a “carve-back” provision that restored coverage for the corporation under certain circumstances, the provision did not apply, since the investigation did not constitute an “administrative or regulatory proceeding” and did not satisfy
- ther conditions set forth in the policy.
The district court further found that the corporation could not be reimbursed for the costs it incurred on behalf of its
- fficers, directors and employees in responding to the SEC investigation. Though the regulatory investigation of an insured
individual qualified as a “claim,” the SEC’s investigation did not meet certain criteria required by the policy. Moreover, the court concluded that the costs of the corporation’s internal investigation and audit could not be characterized as defense costs or a loss within the meaning of the policy. Nationally, case law on this issue is inconsistent, and policyholders need to protect their rights during the process of negotiating the D&O policy. Bump-up Clauses and the Question of Allocation: In Genzyme Corp. v. Federal Insurance Co., No. 09-2485, 2010 U.S. App. LEXIS 21079 (1st Cir. Oct. 13, 2010), the U.S. Court of Appeals for the First Circuit held that a Bump-Up clause in a D&O policy does not prevent a corporation from seeking reimbursement for settlement amounts paid to indemnify its officers and directors. Dissatisfied with the ratio used by the corporation to conduct a share exchange, shareholders commenced a securities class action against the corporation, its board of directors and two officers. The corporation eventually settled all claims for $64 million, and sought reimbursement for $10 million from its D&O insurer. The policy provided that it would cover losses
SLIDE 4 suffered by the corporation to indemnify its officers and directors. In addition, the policy covered losses suffered by the corporation on account of a “securities claim.” However, as is typical of D&O policies, the policy contained a bump-up clause, which excludes coverage for claims where the corporation is alleged to have favored “one class of shareholders at the expense of another.” Given that the underlying action triggered the bump-up clause, the First Circuit affirmed the district court’s decision barring coverage for settlement funds paid to resolve claims made against the corporation. However, the First Circuit found that the bump-up clause did not apply to the amounts paid by the corporation to settle claims made against its officers and
- directors. Thus, pursuant to the allocation clause of the policy, the amount of the settlement attributable to indemnifying
the corporation’s officers and directors needed to be calculated. Genzyme illustrates the significant risks a company takes when funding a global settlement for claims against the company and its officers. Before entering a settlement on behalf of both the company and its management, the insured company should calculate those portions of the settlement applying solely to the indemnification of its officers and directors. In a perfect world, the insured and insurer should agree on the allocation at the time of settlement, but this will undoubtedly be impossible in most cases. Conclusion Though every insurance case is different, these cases share a common theme: D&O policies are not foolproof, and it is becoming increasingly difficult for companies and their management to insulate themselves from risk even in the most common of situations, such as settlement or regulatory investigations. Accordingly, companies must carefully review and negotiate the wording of their D&O policies, and think prospectively about the insurance implications of their business and litigation decisions. Companies must expect coverage denials, and be prepared to litigate.
- -By Robert D. Chesler (pictured) and , Lowenstein Sandler PC.
Robert D. Chesler (rchesler@lowenstein.com) is a member of Lowenstein Sandler PC in the firm's Roseland, N.J., office, and chair of the firm's insurance practice group. Danielle C. Carmona (dcarmona@lowenstein.com), also in the Roseland office, is an associate in the firm's litigation department and a member of its employment litigation practice group and its insurance practice group. The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media, publisher of Law360.
