The D&O E&O Monitor

Insurance Coverage Litigation - Some Food for Thought

Joe Monteleone — Fri, 27 Jan 2012 14:26:55 -0600

Insurance coverage disputes in the D&O and E&O arena provide substantial grist for the mill that is this blog. Perusing these decisions on a daily basis has led me to some interesting conclusions and many unanswered questions.

My career in D&O and E&O insurance began in 1985 as an in-house claims lawyer. Since then, the coverage litigation landscape has drastically changed, primarily as follows.

We are now bombarded with new decisions on almost a daily basis from various sources, including blogs such as this one, law firm newsletters, electronic and print litigation reporting services, legal newspapers, the insurance press and sundry other sources.

Although many of these decisions are ultimately reported officially, and thus will carry more precedential weight than others, there are a host (if not the majority) of decisions that are picked up only on one of the electronic reporting services such as Westlaw or Lexis or are simply unpublished decisions of various courts picked up by enterprising sorts like myself.
Like a black market hidden economy, there are an increasing number of coverage disputes that are resolved without seeing the light of day. In addition to old-fashioned face to face negotiations (which in my opinion is the ideal way to resolve these disputes), many disputes are decided in arbitration – either because the insurance policies contain a mandatory arbitration provision or the parties freely elect to arbitrate. Although arbitration can often be a valuable alternative dispute resolution mechanism, one of the downsides is that the results are typically confidential and, unlike with most court decisions, we do not build up a body of precedent to guide the parties in future disputes. An unfortunate result of this is that parties frequently arbitrate the same issues repeatedly.
Who wins most of these disputes? I am unaware of any statistics in this area, but I just examined the current issue of LexisNexis® Mealey’s™ Emerging Insurance Disputes, a respected source and not one that has any apparent bias in reporting decisions favorable to one side over the other. That issue contained reports on 11 decisions, with six in favor of the insurer and five in favor of the insured. This is a bi-weekly publication, so the fact that there were 11 decisions in it only underscores my point above about the frequency of coverage disputes.

What are your thoughts on these issues? Please use the Comment feature to share them with all of our subscribers or, if you prefer, e-mail me at jmonteleone@tresslerllp.com.

D&O - The Uncertain Insurance Implications of Dodd-Frank

Joe Monteleone — Fri, 27 Jan 2012 12:26:55 -0600

Much has been written about the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) since its passage in July 2010, including conclusions and speculation with regard to its impact on D&O insurers.

The devil is usually in the details when it comes to assessing any legislation, and the devil here lies in the fact that much of the rulemaking necessary to implement Dodd-Frank has yet to be promulgated. Adding to the uncertainty is the fact that all of the viable Republican presidential candidates are opposed to this legislation, in whole or in substantial part. A Republican presidency, perhaps coupled with a Republican-controlled House and/or Senate, may well lead to repeal or amendatory legislation or, at the very least, a different course to the rulemaking activity.

None of the major D&O policy forms on the market today specifically address Dodd-Frank exposures, at least not in the form itself. The primary impact of Dodd-Frank lies in the expected increase in covered claim activity due to generous “bounty” payments to whistleblowers and enhanced ability of the SEC to pursue executive compensation “clawbacks”. Unlike similar provisions under Sarbanes-Oxley, Dodd-Frank expands the compensation clawback beyond just the CEO and CFO to all current or former executive officers. This will likely bring a few other officer (but not independent director) positions into the mix, including the General Counsel, Chief Operating Officer and other duly appointed executives.

Notwithstanding future rulemaking or possible amendatory legislation if there is a change in the current Administration, insureds and insurers may see increased SEC investigatory activity pursuant to Dodd-Frank.

Coverage for clawback amounts should be non-existent because of the personal profit exclusion and the fact that disgorgement of such compensation should be uninsurable as a matter of law. Dependent upon policy language, however, there may be defense costs coverage for these clawback claims. Some commentators have expressed concern that whistleblower claims facilitated by former officers or employees may potentially trigger an Insured vs. Insured exclusion. That policyholder concern may not be well-taken in many instances where there is a “carveout” to the exclusion that addresses these types of situations. Moreover, many of the newer policy forms now contain a simple “insured entity vs. insured” exclusion that should not be triggered by a whistleblower claim in most instances.

In summary, election year politics, particularly if there is an Administration change and significant changes in the make-up of the House and Senate resulting from the November 2012 elections, may greatly affect the future direction of Dodd-Frank reforms. Stay tuned.

E&O - Insurer Granted Rescission of Accountants Professional Liability Policy

Joe Monteleone — Fri, 27 Jan 2012 12:26:55 -0600

I have always maintained, and continue to do so, that rescission is a drastic remedy and not one that is sought often and undertaken lightly by insurers. A recent decision in which an insurer successfully rescinded only illustrates why few situations are egregious enough to warrant rescission and the pitfall for the insured when it has its policy rescinded. Chicago Ins. Co. v. James A. Capwill, 2011 U.S. Dist. LEXIS 147086 (N.D. Ohio, No. 1:01-cv-2588, December 21, 2011).

Capwill involved applications for accountants professional liability insurance submitted in 1997, 1998 and 1999. In each successive application, the principal in the accounting firm made and reaffirmed certain representations as to the nature of his business.

The Court found that the insured had indisputably made intentional misrepresentations on the applications for insurance*, including statements with regard to his investment activities and fee income (fees for servicing fraudulent viatical insurance policies for individuals afflicted with AIDS) and prior license revocation. The insurer successfully rebutted arguments that it was barred by laches because it waited too long to assert its rescission defense. The Court found that the insurer diligently proceeded to develop evidence of material misrepresentation and that the insured was not prejudiced when the insurer timely asserted rescission after developing the supporting evidence.

The Court also held that the determination of materiality is made from the perspective of the insurer, not the insured applicant, and its conclusion is strikingly blunt.

[The insured] lied when he applied for insurance with the [insurer]. He persisted in his falsehoods when he applied for renewal. His motive and intent when he did so are manifest. The questions he fraudulently answered were material to the [insurer’s]decision to issue and then renew the policies, and the pricing thereof. There can be no question that, had [the insurer] been told the truth, it would not have accepted the applications. Its entitlement to rescission is clear.

Neither laches nor doctrines of estoppels, acquiescence or waiver bar the right to rescind.

The cautionary tale here is that, despite the high hurdle of having to prove both a material and intentional misrepresentation, an insurer can still prevail on a rescission claim under the egregious circumstances presented in this case.

*Under applicable Ohio law, it is necessary to establish that the misrepresentations must be material and made with intent to mislead the insurer. In many other jurisdictions, there is no intent requirement in addition to the requirement of materiality.

E&O - Federal Court Turns Lawyers Professional Insurer's Win On Known Claims Exclusion Into Loss on Duty to Defend Issue

Joe Monteleone — Fri, 27 Jan 2012 12:26:55 -0600

While “winning the battle and losing the war” may not be an apt analogy, a recent decision from a Federal court in New York illustrates the perils faced by an insurer in withdrawing a defense as soon as it believes a policy exclusion takes the claim outside the scope of coverage. Schlather, Stumbar, Parks & Salk, LLP v. One Beacon Ins. Co., 2011 U.S. Dist. LEXIS 147931 (N.D.N.Y., No. 5:10-cv-0167, December 22, 2011).

The underlying dispute involved a decision by one of the insured firm’s partners to voluntarily dismiss a wrongful death action, apparently without the express approval of the decedent’s widow. Prior to the application for the policy at issue, the widow notified the firm in writing that she did not consent to the dismissal. The facts established that her consent was solicited but, after it was not received after a passage of time, the firm proceeded to dismiss the action without notifying her.

In upholding the applicability of the policy’s “known claims exclusion,” the Court applied a subjective/objective standard used in New York and many other jurisdictions. Liberty Ins. Underwriters, Inc. v. Corpina Piergrossi Overzat & Klar, 78 A.D.3d 602 (App. Div. 2010). The Court held that the first and subjective prong of the standard was satisfied in that a firm partner knew of the client’s displeasure over the dismissal. The second and objective prong was also satisfied in that the Court held that a reasonable attorney knowing of this client’s displeasure should have anticipated that a claim might arise.

End of analysis and insurer wins?

Not quite.

The Court noted New York law holds that an insurer’s duty to defend is broader than its duty to indemnify, and that duty remains in effect until such time that it is “determined with certainty” that there is no coverage under the policy. Further, under New York law, the insurer’s defense obligation is determined by analyzing the coverage within the “four corners” of the Complaint. Here, the Court found that the allegations that the firm permitted the wrongful death action to be dismissed without the client’s consent and also failed to notify her of the dismissal was sufficient to trigger a duty to defend. The applicability of the known claims exclusion was not known with certainty until a later time. The Court strongly suggested that the best practice for an insurer to protect itself and establish the viability of any coverage defense would be to undertake the insured’s defense and initiate a coverage declaratory judgment action, unless the insured first institutes such an action.

Although not reduced to specific amounts in the Opinion, the Court ruled that the insured was entitled to general and consequential damages as a result of the insurer’s breach of the duty to defend, and ordered the parties to engage in “meaningful settlement discussions” to try to determine the amounts of these damages.

Many insurers are reluctant to incur the expense of a declaratory action, but this decision illustrates the wisdom of so doing.*

*The decision to initiate a declaratory action is even more painful in New York, where the initiating insurer can also be liable for the insured’s attorney fees and costs if it does not prevail.

E&O - Fourth Circuit Narrowly Interprets Broad Form Exclusion in Accountants Professional Liability Policy

Joe Monteleone — Wed, 18 Jan 2012 09:59:35 -0600

On December 22, 2011, the Fourth Circuit reversed a decision of the United States District Court for Maryland in favor of an accountants professional liability insurer with regard to the applicability of an insurance agents and brokers errors and omissions exclusion in the policy. Trice, Geary & Myers, LLC v. CAMICO Mut. Ins. Co., No. 10-1473, 2011 U.S. App. LEXIS 25462 (4^th Cir., December 22, 2011). The insurer filed its Petition for Rehearing and Rehearing En Banc on January 5, 2012. Copies of both the Opinion and the Petition are attached.

The underlying claims against the insured accounting firm involved the creation of defined benefit plans under § 412 (i) of the Internal Revenue Code. The insured helped arrange for the funding of those plans by certain life insurance policies to be purchased by its client, for which it received commission income from the life insurer. The insured advised its client that the premiums paid for those policies would be tax deductible. Ultimately, the IRS disallowed the deduction, allegedly causing significant loss to the client, which sued the insured.

The insurer denied coverage for these claims against the insured based upon exclusionary provisions pertaining to acts as an insurance agent or broker. The key exclusionary language provided as follows.

This insurance does not apply to any Claim in connection with or arising out of any act, error or omission by any Insured in his/her capacity as an agent or broker for the placement or renewal of insurance products or for the sale of annuities. (emphasis added)

The District Court found the exclusion sufficiently broad enough to preclude coverage despite the insured’s arguments that the gravamen of the claim involved negligent tax advice re the deductibility of the premiums paid for the life policies. The insurer successfully argued that although one of the principals of the insured firm may have in fact rendered tax advice, the claims arose from his acts as an insurance agent in procuring the policies.

The Fourth Circuit reversed finding that the exclusion was not broad enough to preclude coverage, essentially because it believed negligent tax advice was the principle underlying claim and that in fact there was another agent involved in placing the life insurance. It also concluded that the receipt of commission income did not affect its conclusion that the insured was not acting as an insurance agent.

I believe this case was wrongly decided and, unless it is reversed upon rehearing, it should be of significant concern to insurers in drafting preamble language to exclusionary provisions. While tax advice may well have been at issue in causing the client damage, and there is no dispute that negligent tax advice is clearly within the scope of coverage under an accountants professional liability policy, the Court apparently lost sight of what should have been the determinative question – did the claims against the insured arise from its acts in procuring the life policies?

Perhaps even more amazing is the Court’s conclusion that, although the underlying claims referenced the insured’s receipt of commissions, it did not specifically allege that they were acting as an insurance agent. Maybe I am being a bit impertinent but, if one receives commissions from an insurance company, what else can that one be but an agent or broker?

The exclusion language here in the “arising out of” format is typically referenced as “absolute” and should have been sufficient to uphold the application of the exclusion to the underlying claim. Although it is uncertain whether this Fourth Circuit panel would have been persuaded otherwise, perhaps insurers need to consider utilizing the “super absolute” language along the lines of “this insurance does not apply to any Claim in connection with or arising out of, whether in whole or in part, any act, error or omission by any Insured.” This may have alleviated the Court’s apparent concern that the claim here arose from more than broking activity.

Crime/Fidelity - Restrictive View of Insurer's Rescission Rights Despite CEO's Misrepresentations on Application

Joe Monteleone — Tue, 03 Jan 2012 15:20:09 -0600

Typically, when the CEO of an organization makes a material misrepresentation on an insurance application as to knowledge (including his or her own) of acts, errors or omissions that might give rise to a claim, an insurer would be able to successfully rescind that policy. A recent decision, however, illustrates why that may not always be the case. Bancinsure, Inc. v. U.K. Bancorporation Inc./United Kentucky Bank of Pendleton County, Inc., C.A. No. 11-109-DLB-CJS, 2011 WL 5570704 (E.D. Ky., November 16, 2011).

In this case, the bank CEO had been embezzling funds from the bank for more than five years to the tune of over $2 million. She was also the signatory on the application completed after or during the course of her embezzlement scheme. The policy at issue was a combined financial institution bond and professional liability policy. Although not quite explicit in the Court’s Opinion, it would appear that the claim made was under the bond portion and where the insured would be the bank itself.

The Court declined to impute the knowledge of the CEO to the bank. Although normally there would be such imputation, the Court relied on an “adverse interest exception” theory to not impute. Under that theory, an agent’s (the CEO) knowledge is not imputed to her principal (the insured bank) when she would have no reason to communicate that knowledge to it, i.e. she would not have reason to disclose her embezzlement to her employer. Further, the CEO was not a de facto alter ego of the bank and was not acting in the bank’s interests by falsifying the insurance application. More specifically, although she had authority to complete the application, the Court held that such authority extended only to completing it honestly.

Finally, and perhaps this is why the result here may be specific to the nature of fidelity insurance, the Court held that the bond was specifically intended to cover the bank for the very loss caused by the embezzlement. If the application had been completed by any other bank officer, there would be no question that the CEO’s knowledge could not be imputed to the bank.*

This decision is another illustration of why successful rescission of a bond or policy is never a “slam dunk”.

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It does not appear that the application or the policy contained any provisions addressing imputation of knowledge or severability of interests.

D&O - EVOLUTION OF THE PRIMARY/EXCESS MARKET RELATIONSHIPS

Joe Monteleone — Tue, 03 Jan 2012 15:20:09 -0600

This month, Advisen published the inaugural issue of its Management Liability Journal. Among the excellent pieces in this new and insightful publication was an interview by Advisen’s David Bradford of my long-time D&O industry colleague, Michael Mitrovic, now at IronShore in an executive position.* The Journal requires a paid subscription and can be accessed at http://corner.advisen.com/journals.html.

Mike makes many thoughtful and well-taken observations on the changing nature of primary and excess relationships and insurer and insured relationships over the past several years. In particular, I would like to address three of the topics covered in the interview and add some further observations of my own.

1. Follow the form, but not the actions of the primary insurer

Mike makes excellent observations about the increasing frequency of excess insurers taking positions contrary to those of the primary insurer, as to whose policy they “follow form.”Of course, as Mike indicates, it is wrong to take a contrary and more restrictive position solely because the excess insurer does not want to pay. There are, however, some instances where the excess may have a legitimately different view of the primary language, which after all is its contractual language too by virtue of the policy’s “follow form” provision. Those rights of the excess insurer were affirmed in a landmark Massachusetts high court decision in 2007 in Allmerica Financial Corp. v. Certain Underwriters at Lloyd's, London, 449 Mass. 621 (Mass. 2007).

Allmerica addressed the very abuses that Mike observes. The excess insurers must still interpret the primary contract correctly, but they are not bound to follow the primary’s position, particularly where, for business reasons not necessarily shared by the excess insurer, it relinquishes valid coverage defenses under the policy.

2. The Qualcomm Issue

Mike also makes note of the difficulty in achieving settlement of coverage disputes separately with primary and excess insurers because of decisions such as Qualcomm, Inc. v. Certain Underwriters at Lloyd’s, London, 161 Cal. App .4th 184 (2008). A number of other decisions, both prior and subsequent to Qualcomm have reached the same result on the same reasoning.

What these decisions do is essentially strictly enforce the “exhaustion provision” in many excess contracts, which provides that the excess insurer shall have no payment obligation until such time that the underlying insurance is exhausted by payment from the underlying insurers. Payments from other sources, including the insured, cannot be used to fill any gaps.

The results in Qualcomm and similar decisions were grounded in the excess policy exhaustion language at issue. As discussed below, the marketplace has already reacted and addressed the problem by changing the exhaustion provisions in most instances. An increasing number of newer excess policy forms, as well as older ones by way of amendatory endorsements, now provide that exhaustion of the underlying limits can take place by any combination of (i) payments by the underlying insurers, (ii) payments by the insured, and (iii) payments from any other source of indemnification or insurance. The latter component is not quite universal and can get a bit tricky in its application, but that is another story for another blog post on another day.

Perhaps the optimal solution here is now, and always has been, to negotiate resolution of coverage disputes contemporaneously with all insurers in a tower. Nothing infuriates an excess insurer so much as when it perceives it is not being offered as fair a deal as others below it in the tower.

3. Additional Protections for Excess Insurers

Where excess insurers are often hamstrung is in decisions by primary insurers to pay their full policy limits without properly vetting submitted defense expenses before exhausting. In many respects, this problem is related to the two discussed above and occurs where the primary quickly realizes that its limits “are toast” and does not want to expend time, effort and, most of all, expense in scrutinizing legal invoices and other submitted items before simply paying them in full.

In such cases, the real parties in interest are one or more excess insurers that will in reality become the working layers of insurance in getting the claim resolved. Yet, it has been difficult, if not practically impossible, for the excess insurers to insert themselves in the defense expense processing.

In a little known opinion, a Minnesota court addressed this issue in Royal Indemnity Company V. C. H. Robinson Worldwide, Inc., A08-0996, Court of Appeals of Minnesota (Decided July 21, 2009). Here, the Court recognized the excess insurers’ dilemma and allowed them to effectively reconsider defense payments already made by the primary insurer. It is uncertain as to what happened in the case after this decision, as the Court stopped short of explicitly stating that some portion of the primary limits had to be restored. Nonetheless, it should be an encouragement to excess insurers to become more involved in the defense expense vetting process when they are the real party in interest and it is apparent that the primary insurer is not vigorously carrying out its rights and duties in this regard.

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*By way of full disclosure, I am grateful for Advisen’s invitation and publication of my article in this issue on the ramifications of the MBIA decision earlier this year, a case that I have also commented upon in this blog and elsewhere.

D&O - No Coverage for Settlement Without Recourse to Recover From Insureds

Joe Monteleone — Mon, 02 Jan 2012 14:43:09 -0600

It is not all that uncommon a scenario for insureds to settle without an insurer’s consent and enter into a stipulated judgment whereby the insured’s rights against its insurer are assigned to a claimant and precluding a financial recovery against the insured. Such a settlement may be appropriate where the insurer has wrongfully abandoned a duty to defend and unreasonably withholds its consent to a settlement but, in most cases, the insureds proceed down this route at their peril and to the ultimate detriment of the claimant-assignee.

A recent Eighth Circuit decision is illustrative. U.S. Bank National Ass’n v. Federal Ins. Co., No. 10-3472, 2011 U.S. App. LEXIS 24623 (8^th Cir., December 13, 2011).

The underlying suit was one brought by a creditor’s trust against a bankrupt insured’s former CFO for breaches of fiduciary duty. The suit settled for $56 million with an assignment from the former CFO to the trust of his rights under the D&O policy at issue. The trust agreed not to seek any financial recovery from him in consideration of the assignment of these rights.

The lower federal court for the Eastern District of Missouri ruled in favor of the primary and excess insurers on the basis that the CFO sustained no loss because he was absolved from any payment obligation.

The Eighth Circuit affirmed on the same basis, i.e. the CFO was absolved from payment by virtue of the assignment agreement. The specific policy language contained in the Loss definition provided that Loss “does not include . . . any amount not indemnified by the Insured Organization for which the Insured Person is absolved from payment by reason of any covenant, agreement or court order . . . .” (emphasis added).

The Court rejected the trust’s estoppel defense, stating that there was no reason for the insurers to be estopped because they abandoned the insured by denying a defense or otherwise contesting coverage. Further, such an estoppel theory, even if otherwise available, could not be used to trump the exclusion found in the Loss definition. Importantly for D&O insurers, the Court drew no distinction between duty to defend policies and duty to pay defense costs policies (such as most D&O policy forms) in enforcing the Loss exclusion for non-recourse settlements.

The result and reasoning here was similar to that in a California decision earlier in the year in Liberty Mut. Ins. Co. v. Electronics for Imaging, No. CIV 484539, Superior Court, San Mateo County, California (Decided March 10, 2011). I would be pleased to share a copy of this decision upon request.

This was a decision that involved a policyholder’s attempt to recover the amount of a stipulated judgment under various excess D&O policies despite the fact that the amount was agreed to by way of a stipulated judgment without any right of recourse against the insureds to pay for any part of the stipulated judgment. The underlying litigation was a shareholders derivative suit and rights under the policy were assigned or otherwise transferred to the plaintiff’s counsel, who then sued on behalf of the corporate insured.

As in many D&O policies, the policies at issue here had a definition of Loss that excluded any amounts for which an insured is absolved from payment by reason of a covenant not to execute. By entering into a “non-recourse” settlement, the insureds breached this policy provision and the Court entered summary judgment in favor of the four excess insurer defendants.

Although an unreported lower court decision, this decision is fully in accord with California Supreme Court’s decision in Hamilton v. Maryland Cas. Co. 27 Cal.4^th 718 (2002). The insured there argued that the insurers were barred from relying on this language because these were not duty to defend policies. The Court, however, viewed that as a distinction without a difference in that the insurers had all acknowledged coverage and never declined to pay any defense costs.

Both of these decisions should make policyholders take pause before entering into any stipulated non-recourse judgment with an assignment or transfer of rights to recover against insurers.

D&O - NERA YEAR-END 2011 STUDY - SOME NOT SO STARTLING OBSERVATIONS

Joe Monteleone — Tue, 20 Dec 2011 14:46:15 -0600

There are many useful analytical tools at the disposal of those tracking exposures in the area of D&O liability and insurance. Among the most prominent and well-regarded is NERA’s annual report on trends in securities litigation. This year’s report was released on Dec. 14, 2011, and is entitled Recent Trends in Securities Class Action Litigation: 2011 Year-End Review. The report can be accessed and downloaded from NERA’s website at http://www.nera.com

NERA and other notable experts release these types of studies and reports at both year-end and mid-year intervals. Although the studies are somewhat consistent in their findings, it never ceases to amaze me how many in the insurance industry attempt to divine significant and long-term trends that the studies themselves do not support. Although NERA correctly concludes that the frequency of new filings has been relatively steady over the past three years. In fact, if one examines the years since the passage of the Private Securities Litigation Reform Act at the end of 1995, most years have somewhere between 200 to 250 companies sued each year in securities fraud class action litigation. The 2011 projected total will be 232 filings, according to NERA, compared with 241 in 2010.

NERA correctly finds consistency in these year-to-year results, but I am sure we will probably see many commentators heralding a significant downturn in securities litigation. Anyone who makes business decisions based upon any misperceived long-term downturn does so at their peril, as proven over and over again in the last 15 years and longer.

What may be changing, however, is what goes into the mix of filings. This past year evidences a remarkable number of actions related to merger and acquisition activity, as well as to “reverse mergers” involving U.S. subsidiaries of Chinese companies.

NERA does observe that the frequency of filings against Chinese companies appears to be decreasing in the second half of 2011. They do not comment on the fact that some of the earlier filings in this area have met with successful motions to dismiss. Also, somewhat of a wild card is the extent to which these companies have significant amounts of D&O insurance and/or U.S. directors who are deep pockets in their own right. It’s too early for any firm conclusions, but lack of success at the motion stage coupled with questionable assets from which to seek recovery may put a damper on significant new filings against Chinese companies in the United States in the near short-term. That being said, however, the long-term outlook in my opinion is that we will see a growth in Chinese subsidiaries in the United States and higher levels of D&O insurance purchased by them. If nothing else, this should make these companies as amenable to securities fraud suits as wholly U.S. risks.

Merger and acquisition activity has picked up in recent years as at least some sectors of the economy have improved. Oftentimes, this litigation is short-lived, but the activity can be intense and costly during its pendency. It is not unusual for defense expenses to range upwards of $10 million in a year‘s time, even if the litigation concludes with a dismissal or non-monetary settlement.

The NERA report should be read in its entirety as it covers much more than discussed in this post and presents some very interesting and useful data.

D&O - DISGORGEMENT: DON'T SAY IT, UNLESS YOU MEAN IT

Joe Monteleone — Tue, 20 Dec 2011 14:46:15 -0600

In a decision that may well be further appealed to the highest appellate court in New York, an intermediate appellate court ruled in favor of insurers in J.P. Morgan Securities Inc. v. Vigilant Ins. Co., Index No. 600979/09, Supreme Court, Appellate Division, First Department (NY, Decided December 13, 2011). A copy of the decision can be accessed here. [JP Morgan.pdf].

The coverage dispute here arose from late trading and market timing claims asserted against Bear Stearns, now part of J.P. Morgan Securities. The claim at issue was a settlement between Bear Stearns and the SEC in which Bear Stearns agreed to pay $160 million in “disgorgement” and $90 million in civil penalties. Coverage, or lack thereof, for the civil penalty portion of the settlement was not discussed in the Court’s Opinion.

With regard to the disgorgement amount, it was memorialized in an Administrative Order entered into by Bear Stearns with the SEC. Although the Order clearly identified the $160 million amount as disgorgement, Bear Stearns argued that it could not be in light of the fact that revenue to Bear Stearns from late trading and market timing conduct totaled only $16.9 million, about a tenth of the disgorgement amount.

In what might be fairly characterized as the right decision for the wrong reason, the Court found that “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.” Thus, there is at least on some level an intellectual disconnect in that Bear Stearns would appear to be disgorging other people’s (“the collaborating parties”) money. The Court does not explain how one disgorges what it has not in fact received, but instead looks to “benefit” received by Bear Stearns in facilitating the underlying transactions.

The policies at issue contained both personal profit exclusion triggered by an “in fact” finding and a dishonesty exclusion triggered by final adjudication. The insurers also argued that the settlement was not insurable loss as a matter of law.

Although the Court did not explicitly address each of the exclusions, it did note that the SEC had found Bear Stearns misconduct to be “willful” in several respects. This begs the question as to why the SEC did not, as it and the New York Attorney General did in so many other market timing and late trading investigations and prosecutions, insist that Bear Stearns not seek indemnification or insurance coverage for the disgorgement or penalty components of the settlement.

Thus, it seems that the SEC could have done a better job of deterring the type of conduct at issue here and assuring that Bear Stearns remained financially responsible for its misconduct. That being said, the Court appears to have decided this case correctly, albeit its reasoning could be subject to legitimate skepticism and further appeal.