Insurance Coverage for Governmental Investigations of Financial Institutions

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1 NOVEMBER 2005 Insurance Coverage Insurance Coverage for Governmental Investigations of Financial Institutions By David T. Case and Matthew L. Jacobs 1 Over the last few years, many companies in the financial services industry have faced an unprecedented wave of scrutiny by federal and state regulators, including the Securities and Exchange Commission ( SEC ), New York Attorney General Elliott Spitzer, and other state regulatory agencies. Companies will likely incur substantial costs in defending against investigations initiated by such regulators, and those investigations will be fraught with risk, as they may subject a company to class actions or other private litigation. When faced with any high-risk claim, a company should examine its insurance coverage program to determine the coverage available to respond to that claim. By way of example, Comprehensive General Liability ( CGL ) policies should respond to claims of property damage, bodily injury, personal injury, and advertising injury. In addition, for financial services companies facing a government investigation, two potentially significant forms of coverage are directors and officers liability policies ( D&O policies ) and errors and omissions, or professional liability policies ( E&O policies ). While D&O policies vary, these policies afford coverage to directors and officers for non-indemnified claims and also afford reimbursement coverage to the entity that is indemnifying the directors and officers in connection with the underlying liability. In some cases, the parent entities and their affiliates also will be covered for certain losses resulting from claims made against an insured for a wrongful act, including any actual or alleged error, misstatement, misleading statement, act, omission, neglect or breach of duty, if the policy contains Entity Coverage. The Entity Coverage afforded by D&O policies issued to publicly-traded companies typically covers securities claims involving the company s own securities, rather than claims arising from investments in other types of securities. Typically, the insured under an E&O policy includes a professional business entity such as a banking institution, a mortgage banking service provider, or a mutual fund complex, as well as the individuals who provide professional services on behalf of that business entity. Often, for large business entities, insurance carriers will package a combined D&O/E&O policy for many reasons, including facility of use, ease of reference and, sometimes, premium savings. If the underlying regulatory investigation is directed at securities-related issues, it is likely that directors and officers may be implicated and, therefore, D&O coverage may be a more likely route of recovery. If the underlying investigation is related to business operations and the employees associated with those operations, it is likely that E&O coverage may afford 1 David T. Case and Matthew L. Jacobs are partners in the D.C. office of Kirkpatrick & Lockhart Nicholson Graham LLP where they have a national practice advising and litigating on behalf of corporate policyholders seeking coverage for matters arising under directors and officers, errors and omissions, commercial and comprehensive general liability, umbrella, excess, first-party, professional and other forms of insurance coverage.

2 coverage for defense costs and indemnity, or the damages, associated with such matters. 2 Although D&O/E&O policies are usually claims made policies, the language of such policies can differ considerably, including variations in the definition of such critical terms as Claim and Loss. Accordingly, this article addresses certain key provisions in these policies, the nature of a claims made policy, and some of the potential defenses to coverage. I. INVESTIGATIONS AS COVERED CLAIMS AND THE DEFENSE OBLIGATION A threshold issue to coverage for a government investigation is whether such an investigation constitutes a covered Claim under the pertinent policy language. In some D&O/E&O policies, a Claim is defined broadly and includes not only formal lawsuits and administrative proceedings, but investigations, which is typically an undefined term. For example, the following language, or a variation thereof, may be found in some policies: Claim means: 1. A civil proceeding commenced by the service of a complaint or similar pleading; 2. Any formal administrative proceeding commenced by the filing of a notice of charges, or formal investigative order or similar document; 3. A demand; or 4. Any investigation into possible violations of law or regulation initiated by any governmental body or self-regulatory organization (SRO), against an Insured for a Wrongful Act, including any appeal therefrom. (emphasis supplied). Under this language, the definition of a covered "Claim" plainly includes investigations by any governmental body of possible violations of law. Once the insured determines that the investigation constitutes a covered "Claim" under the definition in its policy, a D&O/E&O policy should cover the defense costs of responding to the investigations. This coverage for defense costs may prove quite valuable, as a company may need to pay millions of dollars to defend itself against the investigations. Moreover, the obligation to cover defense costs must be honored by an insurer, even if regulators ultimately decide not to bring charges or to file suit. Finally, depending on the facts developed during the investigation, the policy may afford coverage for any settlements or judgments the company pays as a result of the investigations. Although a government investigation may fall within the ambit of a claim, the scope of the corresponding defense obligation may raise issues requiring a close review. One difference between D&O and E&O policies is that E&O policies often include a duty to defend that obligates the insurer to afford a defense to the insured for potentially covered claims, whether frivolous or not, even if the claim includes uncovered matters and covered matters. A D&O policy typically does not incorporate a right or duty to defend, but instead operates to reimburse (or, more favorably, advance) defense costs incurred with the consent of the insurer. II. THE NATURE OF CLAIMS-MADE COVERAGE A critical feature of D&O/E&O policies is that they are generally claims-made policies. This requirement is typically embedded in policy language stating that [t]his is a claims-made policy and, subject to its provisions, [it] applies only to any Claim first made against the insureds during the policy period. No coverage exists for Claims made after the end of the policy period unless, and to the extent, the extended reporting period applies. An insured may pay an additional premium for the extended reporting period. This generally allows the insured to extend the time during which a Claim can be reported to the insurer and covered under the policy, but only for "Claims" based upon Wrongful Acts that took place during the original policy period. III. THE POLICY DEFINITION OF LOSS D&O policies cover Loss resulting from certain claims against insureds. Although the definition of Loss can differ among policies, in some, Loss may be defined as: 2 For purposes of this article, the issues relevant to the availability of coverage for governmental investigations are, for the most part, identical for both D&O and E&O policies, and will be referred to as if the policyholder had been issued a combined D&O/E&O policy. 2 NOVEMBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

3 the total amount which an Insured becomes legally obligated to pay on account of each Claim for Wrongful Acts for which coverage applies, including but not limited to damages (including punitive or exemplary damages if and to the extent that such punitive or exemplary damages are insurable under the law of the jurisdiction most favorable to the insurability of such damages provided such jurisdiction has a substantial relationship to the relevant Insureds, to the Company, or to the Claim giving rise to the damages), judgments, settlements, costs and Defense Costs. Yet under certain definitions of Loss, there will be caveats to the definition of Loss, such as a provision stating that the definition does not include the return or repayment of any fees or commissions charged to clients. Unlike D&O policies that cover Loss, and that are eroded by the payment of defense costs to the extent they fall within the definition of Loss, an E&O policy often pays defense costs in addition to limits of liability. Because insurers may attempt to treat the definition of Loss as a coverage-limiting provision, a policyholder should carefully structure any settlement of an investigation to prevent an insurer from arguing that the settlement falls outside the definition of Loss. For example, if a settlement states that the settlement funds are to pay fines and penalties, an insurer would likely argue that such a payment does not constitute a covered Loss, as the term Loss does not specifically include fines or penalties. Similarly, if a settlement is characterized as a payment for restitution or disgorgement of ill-gotten gains, the insurer may also contend it is not a covered Loss, even though those terms do not appear among the matters that do not constitute Loss. IV. COMMON EXCLUSIONS FREQUENTLY ASSERTED BY INSURERS There are several exclusions found in D&O/E&O policies that may be implicated by government investigations. Fraud and Improper Personal Profit Exclusions Virtually all D&O/E&O policies contain some type of exclusion for improper personal profit, and fraudulent or dishonest conduct. For example, some D&O/E&O policies will not cover a Loss where it is established in fact that the Insureds gained any profit, remuneration or pecuniary advantage to which they were not legally entitled or committed any fraudulent or criminal Wrongful Act with actual knowledge of its wrongful nature or with intent to cause damage. (emphasis added). In contrast, some D&O/E&O policies state that the fraud (and the personal profit) exclusion will apply only for any deliberately fraudulent act or omission or any willful violation of any statute or regulation committed by such Insured Person, if a judgment or other final adjudication adverse to such Insured Person establishes such a deliberately fraudulent act or omission or willful violation. (emphasis added). Known Claims or Circumstances A D&O/E&O policy may contain a known Claims or circumstances exclusion. Such an exclusion provides that the insurer shall not be liable to pay any Loss in connection with any Claim based upon, directly or indirectly arising out of, or in any way involving any Claim and/or circumstances which could give rise to a Claim, of which any of the Insureds has actual or constructive knowledge prior to the beginning of the Policy Period. Based on this exclusion, an insurer might seek to deny coverage on the ground that there was knowledge of the circumstances of the claims prior to the inception of the D&O/E&O policy. Severability A financial institution will also want to determine if the policy contains a severability provision in the exclusions section of the policy. Such a provision protects innocent insureds and establishes that, for purposes of determining whether an exclusion applies, the Wrongful Act of one insured is not imputed to other insureds. Many D&O/E&O policies contain severability for the fraudulent/criminal acts and personal profit exclusions discussed above. Thus, even if an insurer could show illicit profit or fraud by one insured, it could not deny coverage to the other insureds on that basis alone. Misrepresentation Most D&O/E&O policies provide that statements made in the insurance application and materials supporting the application are true and are 3 NOVEMBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

4 incorporated into the D&O/E&O policy, and the D&O/ E&O policy is issued in reliance upon such statements. In several recent high-profile cases such as Enron and WorldCom, insurers have tried to rescind policies as to all potential insureds on the ground that the policyholder misrepresented critical information during the application process. Because rescission renders the policy void from its inception, it is a drastic remedy and the insurer generally bears a heavy burden to prevail. As a result of the recent high-profile efforts by carriers to rescind policies, policyholders have sought severability provisions expressly applicable to representations made in connection with the policy application. These provisions make it clear that misrepresentations, or omissions, made by one officer in connection with the policy application will not operate to void the coverage as to other, innocent officers or directors covered by the policy s terms and conditions. Insurer Consent Many D&O/E&O policies state that the insured shall not admit liability, consent to any judgment, agree to any settlement or make any settlement offer without the Insurer s prior written consent, such consent not to be unreasonably withheld. If an insured fails to obtain the requisite consent, the insurer may not be liable for any damages or Loss arising therefrom. Thus, if a financial institution acts to settle without first seeking its insurer s consent, the insurer may deny coverage. Yet, the D&O/E&O policy also states that such consent is not to be unreasonably withheld, and an insurer may deny consent only if it has a good reason for doing so. regulatory agency or a state Attorney General. Of course, because D&O/E&O policies vary greatly, all policyholders will want to review their particular policies and perhaps consult with experienced insurance counsel to determine whether the policies afford coverage for the defense of the investigations and, if necessary, whether settlements or judgments are potentially covered. David T. Case dcase@klng.com Matthew L. Jacobs mjacobs@klng.com Similarly, some D&O/E&O policies also require the insured to obtain the insurer s consent prior to incurring Defense Costs. Thus, if a financial institution fails to seek an insurer s consent to defense costs, or to the retention of defense counsel in an underlying action, an insurer may refuse to cover such costs on the ground that they were incurred in violation of the policy terms. V. CONCLUSION This article touches upon some of the insurance coverage issues financial institutions may face if they become a target of a government investigation by a 4 NOVEMBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

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