When Trouble Knocks, Will Directors and Officers Policies Answer? Michael John Miguel Morgan Lewis & Bockius LLP Los Angeles, California The limit of liability theory lies within the imagination of the plaintiffs bar. --First Year Law School Professors Everywhere I. INTRODUCTION With the financial institutions crisis in full swing, and investors losing more money daily, creative alternative avenues of cost recovery will inevitably be -- and already have been -- pursued. One such avenue is insurance, specifically coverage for wrongful acts under directors and officers (D&O) liability insurance policies. The answer to the question of whether a claim arising out of a failed credit default swap, investment strategy, or derivative investment would be covered under a D&O policy will fall along party lines: an insurance lawyer will say no and a policyholder lawyer will say not so fast. As with any matter, whether a claim is covered under a D&O policy will depend entirely on a comparison of the nature of the claims asserted, and the identity of the defendants sued. In cases that have been brought to date, the battle lines have been drawn as would be expected, with D&O insurers arguing that an investment or tax avoidance strategy does not meet the definition of a wrongful act under the policy, that the persons actually undertaking the alleged wrongful acts do not qualify under the definition of director or officer, or that a wrongful act is related to another that took place outside of the period of coverage. While it is too early to tell how the currently pending cases will turn out, the only thing we can depend on is that the debate will persist, and as court rulings are made, plaintiffs pursuing such actions will undoubtedly continue to synthesize their claims in an effort to perfect colorable claims for coverage under D&O policies.
II. DEPENDING ON THE NATURE OF THE CLAIM AND THE LEVEL OF SPECIFICITY IN THE PLAINTIFF S ALLEGATIONS, D&O POLICIES MAY PROVIDE COVERAGE D&O policies are a specialized form of coverage, which provide for: (i) claims against a corporation s directors and officers based on acts committed in their corporate capacities; (ii) the corporation s indemnification obligations to its directors and officers for such claims; and (iii) in some instances, the direct liability of the corporation itself for securities fraud. The specific provisions in each D&O policy may differ greatly based upon various facts, such as the nature of the corporation s business and the corporation s financial condition. Here, we examine the most typical form language. III. A DETERMINATION OF COVERAGE MAY BE MADE BASED ON ONE OR SEVERAL IMPORTANT PROVISIONS OF THE POLICY A denial of coverage may be based on one or more factors. An insurer may argue that the type of claims being made against the directors, officer or corporation are not considered wrongful acts under the policy, or that the types of claims being alleged do not constitute a loss under the terms of the policy. Another potential argument is that the claims are based on a series of related wrongful acts, the timing of which may impact whether a claim occurred during a policy period or not. The most important policy provisions in making a determination of coverage are: A) the insuring clauses, B) the policy period and whether it is on a claims made basis, C) what the notice requirements are, D) the definition of loss, E) what is considered a wrongful act or a related wrongful act, F) how the insured is defined, and G) what potential exclusions exist. A. The Insuring Clauses Establish the Type of Coverage Provided There are three primary forms of insuring clauses. Of the three forms, virtually all D&O policies contain directors and officers liability coverage and corporate reimbursement coverage. Entity coverage, the third type, is optional, though it is increasingly found in D&O policies. Sample Wording Directors and Officers Liability Coverage Insuring Clause The Insurer shall pay on behalf of the Directors and Officers any Loss for which such Directors and Officers are not indemnified by the Company and which the Directors and Officers become legally obligated to pay on account of any claim or claims made against him, individually or otherwise, during or after the Policy Period for a Wrongful Act committed or attempted by such Directors and Officers before or during the Policy Period. Sample Wording Corporate Reimbursement Coverage Insuring Clause Insurer agrees to pay on behalf of the Company any Loss for which the Company has, to the extent permitted or required by law, indemnified the Directors and Officers, and which the Directors and Officers have become legally obligated to pay as a result of a Claim where such Claim is first made during the Policy Period against the Directors and Officers for a Wrongful Act which takes place during or prior to the Policy Period. 2
Sample Wording Entity Coverage Insuring Clause for Securities Claim Liability Insurer agrees to pay on behalf of the Company all Loss for which the Company shall become legally obligated to pay as a result of a Securities Claim 1 first made during the Policy Period against the Company for a Wrongful Act which takes place during or prior to the Policy Period. Entity coverage is often limited to only certain type of claims, for example, a securities action claim or claims under federal or state securities law. This limitation is usually accomplished through endorsements or exclusions. B. The Policy Period and Notice Provisions Establish the Time Period for Covered Claims 1. Policy Period D&O policies are generally written on a claims made basis, providing coverage if a claim is made during the policy period, without regard to the date(s) on which the wrongful act occurred. However, the policies often restrict coverage for wrongful acts preceding the policy period through a retroactive date provision or a prior acts exclusion. Sample Wording Retroactive Date Provision This policy shall cover only those claims that are first made against the Insureds during the Policy Period and arising out of or related to a Wrongful Act committed within one year prior to the inception of the Policy Period. Under this form of a retroactive date provision, there would be no coverage for any claim arising out of a wrongful act that occurred prior to the retroactive date of the policy, even if the claim is not first made until sometime during the policy period. Sample Wording Prior Acts Exclusion The Insurer shall not be liable to make any payment for any Loss arising from any Claim alleging a Wrongful Act which occurred prior to the inception date of the Policy Period or after the end of the Policy Period. Any Loss arising out of the same or Related Wrongful Act shall be deemed to arise from the first such same or Related Wrongful Act. Under this type of policy exclusion, there would be no coverage for any claim arising out of a series of related wrongful acts if the first act occurred prior to the inception of the policy period, even if the claim is only first made during the policy period. Though the burden is on the insurer to prove this exclusion, it is particularly salient to claims arising from a series of financial transactions, which may or may not be connected by the parties. For example, an insurer unsuccessfully argued that separate investors who alleged virtually all the same material misrepresentations by the same advisor were not considered related acts. 2 But, at least one court has found that two or more errors, which lead to the same injury, are considered related acts, under a malpractice policy with similar exclusions. 3 2. Notice Provisions The term Claim is frequently defined in D&O policies, though not always. 1 As it would be defined in the policy. 2 Financial Mgmt. Advisors, LLC v. American Int l Specialty Lines Ins. Co., 506 F.3d 922, 926 (9 th Cir. 2007). 3 Bay Cities Paving & Grading, Inc. v. Lawyers Mut. Ins. Co., 5 Cal.4 th 854, 869 (1993). 3
Sample Wording Broad Definition of a Claim Claim means either a) a written demand for monetary or nonmonetary relief made against any Insured, or b) a civil, criminal, administrative or arbitration proceeding made against any Insured seeking monetary or nonmonetary relief. Virtually all D&O policies require the insured to promptly notify the insurer of any claim, as defined in the policy. Under a claims made policy, claims may be covered which are first made during the policy period, even if the claim is not first reported until after the end of the policy period. Under a claims made and reported policy, only those claims which are first made and reported to the insurer during the policy period may be covered. Policies vary, but they generally specify the form and content of the notice, including time limitations for reporting. Further, some policies require notification for merely potential claims. This often has the effect of extending coverage beyond the policy period, when a claim is not actually made until after the policy period has ended, so long as the potential claim was reported during the policy period. Sample Wording Notice of Potential Claims Requirement If during the Policy Period the Insured shall become aware of any Wrongful Act which may subsequently give rise to a Claim being made against the Insured, the Insured shall given written notice thereof to Insurer. Any Claim which may subsequently be made against the Insured arising out of such Wrongful Act shall be treated as a Claim made within the Policy Period. Courts across the United States have differed on whether or not duplicate notice is required under policies which require notice of actual and potential claims. There is a possibility that a claim reported as a potential claim will need to be re-reported once the actual claim has been made. C. The Definition of Loss Describes the Type of Financial Injuries That Will Be Covered for a Valid Claim Sample Wording Definition of Loss Loss means the total amount which the Company or any Director or Officer becomes legally obligated to pay as the result of all covered Claims first made against the Company or any Director or Officer during the Policy Period for Wrongful Acts including, but not limited to, damages, judgments, settlements, and Defense Costs. The definition of Loss is typically limited by certain express exclusions, which are generally contained within the definition. Sample Wording Exclusions in Definition of Loss Loss does not include (1) salaries, wages, overhead or benefit expenses of the Directors or Officers or employees of the Insured Company; (2) punitive or exemplary damages, except where insurable by law; (3) the multiple portion of any multiple damage award, except where insurable by law; (4) criminal or civil fines or penalties imposed by law; (5) taxes; (6) any amount not indemnified by the Company for which the Director or Officer is absolved from payment by reason of any covenant, agreement or court order; or (7) matters uninsurable under the law pursuant to which the Policy is construed. 4
For corporate reimbursement coverage, loss also includes the amounts that the corporation has indemnified or agreed to indemnify the directors and officers for claims made against them for wrongful acts. For entity coverage, loss is usually limited by the type of claim with which the loss is associated. D&O policies generally do not contain a separate duty to defend. Instead, defense costs are considered included in the definition of loss. Accordingly, any policy limit is reduced by the amount of defense costs the insurer pays. Sample Wording Duty to Defend Defense Costs means that part of Loss consisting of reasonable costs, charges and expenses (including but not limited to attorney fees) incurred in defending or investigating Claims, including appeals therefrom. Occasionally, defense costs must be advanced by the insurer, per the terms of the policy; otherwise, the insurer may reimburse defense costs at a later point in time. D. The Definitions of Wrongful Act and Related Wrongful Act Establish the Types of Claims that Will be Covered A Wrongful Act is typically defined to include any error, misstatement, misleading statement, act, omission, neglect or breach of duty committed or attempted, or allegedly committed or attempted, by any company or by one or more Directors or Officers in the discharge of their duties, individually or collectively, or any matter claimed against them solely by reason of their being Directors or Officers. In connection with the prior acts exclusion described earlier, some D&O policies attempt to limit coverage by specifically excluding coverage for any Loss in connection with any Claim based upon, attributable to, directly or indirectly resulting from, in consequence of, or in any way involving any Wrongful Act occurring prior to certain dates, such as the policy inception date or the retroactive date. Termed Related Wrongful Acts, these are claims based on a series of acts which arise out of, are based on, relate to or are in consequence of, the same facts, circumstances or situations. In the context of credit default swaps with a hedge fund, an insurer may consider the allegations of the complaint regarding 1) the timing of the transaction at issue, and 2) whether it was one of several transactions, and if so, when the first transaction occurred. If the swaps were related on the same facts or circumstances, some of which occurred prior to the policy period, coverage could be denied. The inclusion of Related Wrongful Acts in the covered Loss limits the coverage available to the maximum available per Loss, and precludes each Related Wrongful Act from being considered a separate claim and therefore, subject to multiple limits. Occasionally, this benefits the insured when, for example, there is a deductible, which must only be paid once for the entire series of wrongful acts. E. The Definition of an Insured Person Will Establish Whether Coverage is Available for Named Individuals D&O policies provide coverage for the Insured, which includes directors and officers as they are defined in the policy, either directly or in the form of reimbursement to the corporation for covered amounts incurred on behalf of the directors and officers. Older D&O policies frequently do not cover the corporation itself for wrongful acts, or for its vicarious liability for the wrongful acts of its officers and directors. Now, however, D&O policy forms often extend entity coverage to the corporation for specified types of claims, e.g. for violation of federal and state securities laws, thereby including the company in the definition of Insured for certain claims. The individuals included in the definition of Directors and Officers can often be extensive, as the definition can be quite broadly interpreted. 5
Sample Wording Definition of Directors and Officers Directors and Officers means any persons who were, now are, or shall become duly elected or appointed directors, officers, trustees, managers, or divisional officers of the Company, or with respect to a Subsidiary incorporated outside of the United States, their functional equivalent. Depending on the allegations contained in the complaint, this broad definition may be interpreted to include even low level managers. This determination is based upon an analysis of the description provided in the complaint of the individual s role and position within the organization. The specificity with which the person s role and position is described also influences whether the person may be considered a covered Director or Officer. Employees, at any level, if described as managers in the complaint are likely to be covered. Even if a person is not identified specifically as a manager, if the description in the allegations indicate managerial or supervisory responsibilities, an argument for coverage is possible. F. Exclusions Limit Otherwise Available Coverage Though claims for willful acts are often excluded from any type of insurance coverage by statute, many D&O policies contain provisions explicitly excluding fraudulent, dishonest, or criminal acts. Sample Wording Exclusion for Fraudulent, Dishonest or Criminal Acts The Insurer shall not be liable to make any payment for Loss in connection with any Claim made against any Insured: 1) brought about or contributed to by any deliberately fraudulent or deliberately dishonest act or omission or any willful violation of any statute or regulation by such Insured or 2) for an Insured gaining any personal profit, remuneration or advantage to which such Insured was not legally entitled. This exclusion is often tempered by the requirement that there be a judgment or other final adjudication adverse to the Insured, which establishes: 1) the deliberately fraudulent or deliberately dishonest act or omission or willful violation, or 2) the gaining of any personal profit, remuneration or advantage. Moreover, courts have interpreted this provision to apply only to an intentional act, therefore extending coverage for negligent misrepresentations or failure to supervise others. A court may also consider whether a person was legally entitled to profits based upon actions taken by others in the exercise of business judgment. Other exclusions are possible, but rare, and may impact coverage. For example, some D&O policies have exclusions for actions initiated by regulatory agencies against the insured, actions related to securities, insider profits or trading, and rarely, for Racketeer Influenced and Corruption Organization Act ( RICO ) claims. 6
ABOUT THE PRESENTER Michael John Miguel is a partner in the Litigation Practice Group, where he is focused on commercial litigation, including insurance recovery, environmental litigation, toxic tort defense, antitrust, and intellectual property. Mr. Miguel is a trial lawyer, acting as lead counsel for energy, petrochemical and manufacturing clients in several cases nationwide, involving allegations of property damage, bodily injuries and damage to the environment as a result of current of historic operations. Mr. Miguel also pursues insurance recoveries for liabilities of his clients, who have received over $1 billion in judgments and settlements. Mr. Miguel has acted as outside national and regional counsel for clients, including major oil companies for environmental and insurance litigation matters, and successfully defended the largest groundwater contamination class action suit ever certified in California. Business-First Approach While a trial lawyer, Mr. Miguel understands and appreciates that clients view litigation in the overall context of business operations, and that most cases where parties act reasonably should settle before trial, unless non-monetary objectives dictate a case be pursued to formal resolution. The business objectives of the client are always the guiding principle of litigation strategy. Trial Practice Mr. Miguel has appeared and argued before courts in thirteen states, and tried cases in both federal and state courts, to juries and to the bench, on behalf of plaintiffs and defendants. His success is the result of the ability to communicate complex, technical issues and information in an understandable, effective and persuasive manner. Education J.D., University Of Southern California Law Center 1989 B.A., University of California at Los Angeles, 1986