Law and Insurance

D&O Insurer Prevails On Coverage Challenge to Katrina Loss

Carolina Cas. Ins. Co. v. James E. Sowell, et al., No. 3:07-CV-1783-D (N. D. Tex. February 17, 2009)

I have a confession.  I usually write about general liability policy decisions because the coverage issues tend to be simpler and more accessible to risk managers than, say, Directors & Officers (D&O) policy issues, as presented in this case.  In troubled economic time like these, however, insurance covering liability for a company's mistakes and misadventures is perhaps now worth a little more consideration than in fat years.  Besides, the facts are fairly straightforward and the issues instructive to all who purchase D&O insurance.

The insureds are three apparently affiliated entities in the oil and gas supply business in or around New Orleans and their officers and directors, including James Sowell, a principal of one of the entities (James Sowell Co, L.P.) and a  shareholder/director of DGS, L.L.C., another insured entity apparently run principally by Leonard Doussan III, Leonard Doussan, Jr. and others (DGS, L.L.C. was formerly called "Doussan Gas & Supply, L.L.C."). 

OK, I lied.  The facts are as twisted and serpentine as the snake pit in Indiana Jones' first movie.  Also, the scene is New Orleans after Katrina, so nothing about this will be simple.  Let me, therefore, cut to the chase. 

The risk management function for this assortment of corporate bedfellows appeared to reside with DGS.  Katrina severely damaged the companies' facility, leased from a company called Doussan Properties, L.L.C., and DGS had failed to buy enough property insurance to cover the losses.  Lawsuits followed in rapid order.  Let me mention only two.  First, Doussan Properties sued all the insured entities for failing to maintain adequate insurance as the lease required.  Second, James Sowell sued the DGS and the Doussan clan in a shareholder derivative action for a variety of mismanagement sins, including failing to purchase adequate insurance.

Happily, DGS had purchased a D&O policy that seemed to cover a broad array of "wrongful acts" by the companies and management.  A D&O policy is much like a buffalo.  Looked at head-on, it appears massive, but by the time one reaches the tail, it has tapered down to one of the animal kingdom's smallest butts.  The insuring agreement of most D&O polices appears to cover about anything an officer or director might be accused of doing, any mistake, misstatement, misrepresentation, error or omission.  Down and dirty fraud and deliberate or criminal wrong doing is excluded, but otherwise, the insuring agreement appears quite broad.  However,  when the exclusions and limitations and conditions are rolled out, to say nothing of the endorsements that often add more exclusions, limitations, and conditions, the scope of coverage has shrunk. 

The D&O insurer quickly denied the claim for liability coverage for all the actions against all the insureds, corporate and personal, for a number of reasons.  I mention two.  First, the policy contained a "contract" exclusion eliminating any claim:

based upon, arising out of, directly or indirectly resulting from, or in consequence of, or in any way involving any oral or written contract or agreement.

In other words, any time a lawsuit comes within 100 miles of a contractual dispute, the insurer will probably cry, "contract exclusion."  In this case, it's not even close.  The landlord's suit for breach of lease clearly falls within the contract exclusion. 

Second, the policy excludes any claims against any insured "by, on behalf of, or in the right of the Insured Entity, or by any Directors or Officers."  James Sowell was a director as well as a shareholder of DSG.  Therefore, his suit against DSG and other directors clearly fell within the "insured-vs-insured" exclusion, even though the policy carved out (and so covered) shareholder derivative actions.  The carveout applied only if the derivative action was instigated and continued totally independent of, and totally without the active participation of another insured.  Because Sowell was an insured director and instigated and drove the derivative action, the claim was excluded.

These claims were rightly denied.  D&O insurance is crafted to avoid covering internal company squabbles or situations like this, in which one affiliate makes a mistake that costs the enterprise a great deal of money, so the insureds seek to recover the loss by initiating litigation hoping the loss will be covered as an insured liability.  Often, however, exclusions that hit everything "arising out of " this or that are over-inclusive.  Take the litigation mess we are beginning to see from the subprime mortgage fiasco.  Shareholders with arguably legitimate claims for financial institution mismanagement bring derivative or direct actions, pointing perhaps to a misrepresentation in an SEC filing.  Should D&O coverage for that kind of claim be excluded because back down the line the whole thing started with a mortgage contract? 

I doubt D&O insurers would even try to make that case, but the message here for risk managers is to be aware of the unintended reach "arising out of" exclusions can have.

D&O Insurance Rates Expected To Hold Steady Except For Financial Institutions

Because shareholder actions are expected to proliferate against finacial institutions caught in the subprime mortgage debacle, it should come as no surprise that premiums for directors and officers insurance for those institutions are beginning to rise.  So says Kristin Gunderson Hunt in an article in "Business Insurance."  See D&O Rates on the Rise.  In the past month, D&O rates have climbed 5% to 10% for fincancial institutions.  For companies in other industries, rates may have stopped declining as in the past three or four years, but they do not appear to be rising.

 The number of such lawsuits and the nature of the allegations asserted by shareholders and investors remains to be seen.  From what is already known, however, the class-action plaintiffs bar will have much to work with: incredibly lax mortgage underwriting procedures, bogus or baseless valuations of impossibly complex securities, overly rosy projections, tardy disclosures, blind-leading-the-blind investment strategies --- it won't be pretty.  Perhaps we will not see as much dirty fraud as in the Enron case, but early indications portend an industry-wide recklessness not seen since the captain of the Exxon Valdez lumbered through Prince William Sound.

However, reports Ms Hunt, companies not subject to these lawsuits should have little trouble obtaining D&O coverage at no worse than expiring rates.

Unjustified Severance To Departing Officer Is Uninsurable Disgorement, Says Houston Federal Court

National Union Ins. Co. of Pittsburgh v. U.S. Bank and John Stanley, # 4:07-CV-1958 (S. D. Tex., June 11, 2008)

Because Texas courts rarely have the opportunity to interpret directors and officers (D&O) insurance policies, the U.S. Bank decision is worth a look.  This case concerns D&O coverage, or lack of it, when an insured officer of a failing company was forced to disgorge his $2.27 million severance payment in a bankruptcy proceeding (the company was insolvent at the time), even though the severance had been approved by the board of directors.  The defendant officer sought reimbursement from his D&O insurer.  However, the insurer denied coverage arguing that covered "loss" did not include (1) matters uninsurable under the law, or (2) profit or advantage to which the insured was not legally entitled.  Disgorgement, said the insurer, is both uninsurable and an justified profit.

By the way, the distinction between loss or damage on the one hand and disgorgement or restitution on the other is a hotly contested insurance issue across many jurisdictions and many lines of insurance, not just D&O.  If the insured is simply giving back what it had no right to receive in the first place, then insurance shouldn't provide a windfall to the insured.  But it is not always easy to tell the difference between money damages and disgorgement of money.

In this case, U.S. Bank was in trouble long before the current D&O insurer, National Union, came on the scene.  The bank went through bankruptcy in 1999, and was back in business in 2000 under a reorganization plan that put John Stanley in the driver's seat as CEO for at least three years.  The plan provided for a severance payment of varying amounts depending on whether or not termination was for cause.  The bank continued to fare poorly.  In 2002, the board determined to exercise the termination option.  After tough negotiations (in which Stanley threatened to drag the bank through litigation if he did not get favorable severance terms), Stanley agreed to resign, and the board agreed to characterize his resignation as "termination without cause," allowing Stanley to receive up to $3 million severance.  If he reigned, he got no severance.

Back to bankruptcy court.  The bank was insolvent at the time severance payments were made to Stanley, and the liquidating trustee (curtains for U.S. Bank) sought to recover the payment as an avoidable preference and a fraudulent transfer.  In an adversary action, the bankruptcy court found that Stanley was a bank insider during negotiations of his severance, that he in fact resigned, and thus was entitled to no severance.

Stanley sued National Union for indemnity of the disgorged severance arguing that he incurred a covered loss under the D&O policy.  Stanley argued that he had a clear contractual right to the severance.  He was not giving back that to which he had no right.  Wrong, said the court.  The underlying adversary action determined that he had no contractual right because he resigned voluntarily.  The board action characterizing the resignation as termination for cause was done under threat of litigation and thus was a sham transaction. 

Accordingly, said the court, the payment was both an uninsurable disgorgement and a profit or advantage to which Stanley had no legal right.  Summary judgment for National Union granted.  Case dismissed.

In view of the lower court's determination that Stanley had no contractual right to the severance, this is an easy case for the district court.  However, as mentioned above, it is not always so easy to distinguish loss from disgorgement.  In many transactions, after money has changed hands or securities have been bought and sold, what seems to be loss or damage to the allegedly injured plaintiff can also be called unjust enrichment to the defendant.  So, is the plaintiff recovering damages, or is the defendant disgorging ill gotten gain?  Policyholders should be aware that insurers press the later position frequently and vigorously.

Pollution Exclusion in D&O Insurance Policy Should Not Completely Bar Shareholder Securities Claim, Says Canadian Court

Boliden Ltd. vs Liberty Mutual Ins. Co., 85 O.R. (3d) 492 (Ontario Superior Court of Justice, April 1, 2008) see Boliden Decision

Several years ago, a federal appeals court sent shivers through many American boardrooms by ruling that a securities lawsuit, brought derivatively by shareholders over alleged misrepresentations in SEC filings, was not covered due to a pollution exclusion in a Directors & Officers (D&O) insurance policy.  It seems that the alleged misrepresentations concerned management's failure to report certain fines and costs for a subsidiary's mishandling of waste (the company was in the waste-hauling business), and the exclusion applied to any claims "arising out of pollution [including waste])."  See National Union Fire Ins.Co. v. U.S. Liquids, Inc., 88 Fed. Appx. 725 (5th Cir. 2004).

U.S. Liquids never expected its D&O insurer to cover pollution lawsuits or clean up costs, but it was shocked to learn that it had no coverage for shareholder securities actions simply because the remote subject of alleged SEC misstatements related to operations that related to pollutants.  Foul!

In a case of first impression in Canada, the Boliden court reached the opposite conclusion, at least in part.  The facts are substantially similar to those in U.S. Liquids.  A Spanish subsidiary owned a mine which flooded large tracts of land with contaminated tailings after a dam failed.  Boliden's shares plummeted, and shareholders sued the company alleging misrepresentations in a Prospectus issued a year before the disaster in an initial public offering.  The D&O insurer refused to cover the claims relying on the pollution exclusion ("[Insurer] shall not be liable under this policy to make any payment for loss respecting a claim . . . for or in respect of pollution loss.")

Boliden argued that the loss in question was the drop in value of its shares, not the damage to land and rivers in Spain.  Insurer said the loss in value of shares was caused by the discharge of pollutants and so fell within the exclusion.  Liberty also pointed to U.S. Liquids and other American cases.  However, the Canadian court noted that the American cases applied very broad "but for" causation, which Canadian courts do not accept.

Finding little helpful guidance from Canadian cases discussing causal language (such as "arising out of," "attributable to," and resulting from"), the Court made its own analysis and determined that some of the allegations did not sufficiently involve pollution, though some did.  For reasons not fully explained, the court held that allegations regarding construction defects and poor maintenance of the dam were not excluded, but other allegations were excluded.  The policy contained an allocation clause requiring Liberty to pay 80% of the defense costs where claims involved both covered and uncovered claims.  Accordingly, the court required Liberty to cover 80% of the loss.

Although the result is a victory for the policyholder, the holding may offer little useful guidance if the issue arises again in Canadian jurisprudence.  The court's analysis is very fact-specific.  The best advice to policyholders is to get enhancements to the pollution exclusion before experiencing a loss.  Most D&O insurers are willing to carve out from the exclusion shareholder derivative actions or claims against individual insureds.  The D&O market is still soft, and underwriters are generally in an accommodating frame of mind.  The best way to fix questionable policy language is before a claim is asserted.

Federal Courts Reach Opposite Results Over Scope of Insured vs Insured Exclusion in D&O Policies

Home Federal Sav. & Loan Ass'n v. Federal Ins. Co., No. 06-CV-3053 (N.D. Ohio, September 14, 2007); 

 

Westechester Fire Ins. Co. v. Wallerich, No. 07-2145 (D. Minn., September 25, 2007)

 

These two Federal District Courts reached opposite results on whether an "insured vs. insured" (IvI) exclusion in a directors & officers (D&O) liability insurance policy excludes all coverage for the entire lawsuit when only one of several plaintiffs is an insured under the policy.  (As the name implies, the IvI excludes any “Claim” brought or maintained by any insured).  The Minnesota court held that because the policy defined “Claim” as “a civil proceeding . . .,” the exclusion should apply to the entire lawsuit, not just to the insured’s claim.

 

The Ohio court held that the exclusion applied only to the insured plaintiff's claim and allowed coverage for the claims asserted by the other plaintiffs, because the term “Claim” could refer to separate civil proceedings had each plaintiff filed its own lawsuit.  Therefore each plaintiff’s claim is separable.

 

Also, the Ohio court held that “Claim” may be ambiguous because the term is used elsewhere in the policy to refer to the allegations asserted, not the civil proceeding as a whole.  Specifically, the Ohio court looked at the policy’s defense-cost-allocation clause that pre-sets the percentage of total defense costs the insurer will pay when a lawsuit alleges both covered and uncovered “claims.”  Therefore, the insured’s Claim may be separated from the other Claims and excluded without excluding the other Claims.

 

Apparently, neither policyholder argued that the Claims should be separated because the definition of ”Claim” includes more than just “a civil proceeding, . . .”  Most D&O policies include “a written demand for monetary or non-monetary relief” as a “Claim.”  Accordingly, any case that was preceded by several demand letters, as often happens, began with several “Claims.”  Arguably, most courts would be reluctant to accept an interpretation of the term that allowed a different result depending on whether the demand letter or the civil action was used as the operative “Claim,” or whether the plaintiffs wrote separate demand letters. 

 

The Minnesota court may have reached its decision based on the fact that the plaintiffs were husband and wife, and the wife had nothing really to do with the company other than to receive assets in the marital estate.  In other words, the lion’s share of the “Claim” was against the insured husband.  In the Ohio case, by contrast, the insured plaintiff was one of many shareholders suing the company.

Analysts Predict SEC Will Require Corporate Disclosures of Global Warming Risks

In mid September, a number of state pension funds, treasurers, attorneys general, and interested organizations petitioned the US Securities and Exchange Commission (SEC) to issue an interpretive release clarifying that material climate-related information must be included in corporate disclosures under existing law.  See SEC Petition for Interpretive Guidance.  Earlier this month, the Kiplinger Report stated that the SEC would issue such guidelines under pressure from investor groups, who want to know the companies most at risk for future climate-change lawsuits and what they are doing to reduce carbon emissions.  See Kiplinger Report on SEC Disclosures.  Other analysts have echoed that prediction.

Risk from global warming is, of course, a huge potential insurance nightmare (or opportunity), both from a property/casualty standpoint and that of corporate governance.  Insurance companies themselves may be targeted for failing to disclose foreseeable environmental risks.  SEC action could exacerbate the risk potential.  One of the last times the SEC issued a bombshell interpretive-guidance release was after Enron when the agency announced that disclosure of off-balance-sheet transactions had always been material information under existing law (leaving the plaintiff's bar to infer that corporations that had failed to make such disclosures were potentially liable). 

What will happen to companies that did not disclose climate-impact information in their 2007 disclosures but do so in a big way in 2008?  If 2008 witnesses a recession, then unhappy shareholders may put the blame for sliding stock prices on failures to disclose environmental risk factors, whether this is justified or not.  Either way, the increase in securities lawsuits almost certain to follow will test the softening D&O insurance market.  Interesting times lie ahead.

Justices Impose Greater Burden on Investors in Securities Fraud Actions

The United States Supreme Court ruled yesterday that investors suing companies and their directors for securities fraud should not be permitted to proceed with their action unless they can "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind," which the law defines as "the intention to deceive, manipulate or defraud" (generally called "scienter," Latin for "knowingly" or degree of intentionality).  In the Private Securities Litigation Reform Act of 1995, Congress required the showing of a "strong inference" of scienter but provided no guidance to the courts as to what that means.

In this action. investors sued Tellabs, Inc. and its CEO for allegedly overstating revenue projections.  The lower court had held that the suit should be allowed to go forward if a "reasonable person" could infer that the person acted with the required intent.  Speaking for the 8-1 majority of the high court, Ruth Bader Ginsburg rejected this standard and held that “The inference of scienter must be more than merely ‘reasonable’ or ‘permissible’ — it must be cogent and compelling, thus strong in light of other explanations.”   The lone dissenter, John Paul Stevens, said that he would require "probable cause," the standard required in a criminal indictment, arguing that Congress would not placed a high burden on a plaintiff in a civil action than is required of the state in a criminal proceeding. 

This decision is seen as a significant victory for public companies.  For a fuller description of the Tellabs decision, see N.Y. Times article.

The "Sole Capacity" Limitation in D&O Policy Held Not To Exclude Coverage Where Insured Was Sued As Both Director and Owner

McAninch v. Wintermute, 478 F.3d 882 (8th Cir. 2007)

Most D&O policies cover past, present, and future officers and directors, but only for wrongful acts committed "solely" in their capacity as officer or director.  In this recent case decided by the Eight Circuit Court of Appeals, two individuals purchased a bank that was closed and put into receivership a year later.  The owners, who were also directors, were indicted on several counts for misconduct occurring both before and after the purchase.  One of the directors (the other died before trial) was acquitted on all counts based on conduct while she was a director.

In a subsequent insurance coverage action, the director sought to recover from the bank's D&O insurance policy defense costs related to the alleged conduct when she was a director.  The insurer denied coverage because the indictment alleged both covered and uncovered conduct, including conduct before she became a director and conduct as an owner, and so not done solely in her capacity as a director.  The insurer also denied because the policy excluded claims brought by any state or federal official or agency.

The trial court had granted summary judgment in favor of the insurer.  The appellate court reversed in part holding that an insurer could not avoid its obligation to reimburse the defense costs related to covered claims simply because other uncovered claims were also asserted.  The indictment clearly alleged conduct in her capacity as a director.  The court distinguished other cases refusing to find coverage where the director was sued in a dual capacity, as for example, both as a director and a general counsel.  Here the court held that, although the indictment did allege that the director was acting both as a director and owner, neither the prosecutor nor the insurer explained how the defendant's status as an owner facilitated the wrongdoing.  Without any such explanation, the court held, to deny coverage "would invite carriers to deny coverage based on factors unrelated to the risk undertaken.

The court also held that the government official/agency exclusion did not apply to a criminal case brought by the government as representative of its citizens.

Towers Perrin 2006 D&O Insurance Report Shows Increased Interest In Directors' Personal Protection

The D&O Liability 2006 Survey on Insurance Purchasing and Claims Trends conducted by Towers Perrin (see Towers Perrin 2006 D&O Survey) reveals an 16% increase in inquires from potential board members about their personal protection, as well as a substantial increase in the purchase of Side A-only D&O coverage.  Side A-only policies are typically sold to supplement a company's primary D&O insurance program and cover only individual insureds, not the company, and only if the company is not indemnifying the individuals.  However, the Side A-only product is usually non rescindable, and covers officers and directors even if the primary D&O policy is rescinded or otherwise fails to cover the liability.  Towers Perrin surveyed over 2,800 companies on trends in D&O insurance purchases and claims. “For the first time, a study is confirming a significant change in how companies are protecting directors and officers from personal liability,” said Michael Turk, Senior Consultant.  “While Side A-only coverage has been growing in popularity over the last few years, we now have data to show just how prevalent the coverage has become.”  The survey reflects that companies purchased higher limits, more coverage enhancements, and fewer exclusions than in 2005.  Towers Perrin expects this trend to continue.  The survey also reflects a continuing softening of the D&O insurance market.  The survey's index of average D&O insurance premiums shows a decrease of 18% in 2006 following a 9% drop in 2005 and a 10% drop in 2004.  Securities claims filings also dropped in 2006.

For the first time, Towers Perrin is offerring the 2006 Directors and Officers Liability Survey free on its website at www.towersperrin.com.

Supreme Court Ruling on Greenhouse Gas Regulation Could Have Direct Impact on D&O and Environmental Insurance

The U.S. Supreme Court's remarkable decision in Massachusetts v. EPA (see text of opinion) requiring the EPA to reconsider its decision not to regulate greenhouse gases has ramifications beyond environmental regulation.  By holding that carbon dioxide may be a "pollutant" and so may be regulated under the Clean Air Act, insurers are armed with a powerful argument that corporate losses and liabilities that arise from the effects of global warming are excluded under insurance policies that contain a pollution exclusion.  These might include general liability policies, property policies, directors and officers ("D&O")liability policies, and other types of liability insurance.  Each of these is likely to contain an exclusion for loss or damage arising from an actual or alleged discharge, dispersal, release, or escape of "pollutants."

The area of greatest concern to corporate policyholders is probably D&O insurance. Many companies are just now beginning to try to access risks to their businesses from the effects of global warming.  The Supreme Court discussed the scientific data predicting imminent rises of sea levels.  It is easy to foresee a slurry of shareholder class action lawsuits against companies adversely impacted by global warming alleging management's failure to adequately anticipate and prepare for these changes.  Because greenhouse gases are "pollutants" according to the Supreme Court, arguably, these shareholder actions could be excluded because the alleged losses arise, even if indirectly, from the release of greenhouse gases. 

For a thoughtful discussion of this Supreme Court decision, see law and environment.