Conserving D&O Insurance Policies in Securities Fraud Litigation: A Common Interest of Policyholders and Institutional Shareholder Claimants

by John H. Mathias, Jr. and Timothy W. Burns

Accordingly, it follows that the commercial D&O John H. Mathias, Jr., an experienced trial lawyer, is the insurance product is specifically designed and in- Chairman of the Insurance Coverage Litigation & Counseling tended to respond in situations where the director, Group of Chicago’s Jenner & Block, LLP. h officer, and/or company insureds either have done Mr. Burns is a partner in that Group and currently serves or are charged with doing something actionable as Co-Chair of the American Bar Association’s Insurance Cover- under the law. By contract, the insurance company age Litigation Committee. h has agreed to stand in the shoes of its allegedly Messrs. Burns and Mathias are co-authors of Directors & Officers wrongdoing insureds to the full extent of its policy’s Liability: Prevention, Insurance and Indemnification (Law Journal Press 2000). limits of liability. Although arguments can be (and have been) made that indemnity contracts for liabil- ity like this should not be enforceable as a matter of public policy, we will not address them here except to note that, under most circumstances, courts will strictly enforce D&O liability insurance policies I. D&O Insurance Is Intended To Cover as written. It should be apparent to all, however, that Alleged Wrongdoing insurance companies electing to participate in the In examining the impact of D&O insurance on commercial marketplace of offering contractual in- securities fraud litigation, it is important not to ignore demnity to directors, officers, and companies for an often overlooked two-part truism: (1) D&O liabil- securities fraud claims do so with their eyes wide ity insurance is a commercial product by which an open. insurance company, in return for a fee, contracts to It is highly anomalous, therefore, that modern big indemnify director, officer, and company insureds damages securities fraud litigation almost invariably for certain kinds of financial liability; and (2) direc- involves, at some level, finger pointing in the form tor, officer, and company insureds will have no of actual or threatened coverage denials by D&O liability unless they are held to have done something insurers in the aftermath of accusations by injured actionable under the law. claimants that the defendant insureds have done something actionable under the law for which they Second, D&O polices contain adjudicated “delib- should be held liable to pay damages. The underlying erate fraud” exclusions. Because of this exclusion, thesis of this article is that both the insured defen- insurers have asserted that D&O policies, which have dants and the allegedly injured claimants have every a primary purpose of protecting directors and officers right to expect that D&O insurers will be closely against securities fraud lawsuits, provide no coverage involved in providing the financial resources for if the director, the officer, or the company is found resolving big damages securities fraud litigation, liable in a final judgment for deliberate securities even though it involves allegations of serious wrong- fraud.1 Given insurers’ oft-stated views on this doing. It is a secondary, but nevertheless fundamen- exclusion, it may be no accident that there appears tal, underlying thesis of this article that sanctimony to have been only one state and three federal securi- from D&O insurers has no place in the ultimate ties lawsuits against directors and officers to have resolution of the kind of serious securities fraud gone to trial in the last thirteen years. 2 To prevail litigation claims that created the market for their at trial is to risk forfeiture of the D&O insurance insurance products in the first place. proceeds. Third, in purchasing D&O insurance, policyhold- “The underlying thesis of this article is that ers typically are required to warrant the accuracy of both the insured defendants and the allegedly their previous public financial filings in the applica- injured claimants have every right to expect tion process. Accordingly, when a company restates that D&O insurers will be closely involved in its financials and securities fraud lawsuits follow, an providing the financial resources for resolving insurer may attempt to rescind coverage by arguing big damages securities fraud litigation, even that the restatement itself amounts to an acknowl- edgement of a material misrepresentation, and there- though it involves allegations of serious wrong- fore conclusively proves that the insurer was de- doing.” frauded in the application process.

II. D&O Insurance and Securities Lawsuits III. Common Points of Interest D&O insurance has been shaped by securities Securities plaintiffs, whether individual sharehold- litigation, but it also shapes securities litigation. ers or institutional investors, typically try to maxi- Most D&O policies provide three distinct types mize their monetary recovery by trying to obtain as of coverage: (1) coverage for the directors and large a portion as possible of (1) the D&O insurance officers when the company cannot or will not indem- proceeds; (2) a company’s balance sheet; and (3) the nify them; (2) coverage for the company for sums personal assets of the directors and officers. For their it pays directors and officers as indemnification; and part, directors, officers, and the company are moti- (3) coverage for the company for securities claims vated to ensure that any recovery comes exclusively brought against it (so called “entity coverage”). from insurance proceeds. Three features of D&O policies drive the litigation These interests can conflict. To the extent the and settlement of securities class actions. securities plaintiffs seek a director’s personal assets or a company’s own assets, they can expect the litigation to last longer and be even more hard fought “[T]he longer and harder fought the securi- than it otherwise would. Ironically, at the end of the ties litigation, the smaller the available recov- day, the potential additional recovery available from ery under the D&O policy.” the personal assets of directors and officers may be smaller than the reduction in available insurance First, the financial limits of D&O policies are eroded proceeds occasioned by going after those assets. by the directors’, officers’, and the company’s de- At least in part, however, securities plaintiffs and fense costs. D&O policies require an insurance the insured directors, officers and companies seek company to pay or advance defense costs, but pay- the same objective. All want to maximize the amount ment of defense costs reduces the policy’s limits of of insurance proceeds available to assist in resolving liability. Thus, the longer and harder fought the the dispute. This common objective creates common securities litigation, the smaller the available recov- points of interest. ery under the D&O policy. Ironically, by naming more defendants, plaintiffs in a securities fraud A. Appointing a Conservator lawsuit may actually reduce their ability to recover from D&O insurance policies — more defendants What is seldom done, but what should be routine, will consume more of the D&O policy proceeds in is for both D&O policyholders and securities plain- defense costs before a recovery is obtained. tiffs to appoint separate “conservators” of the D&O insurance policies — a person charged with ensuring to do so. Efforts, however, should be made to review that (1) insurers are not given undue ammunition to the policies immediately. The amount and scope of deny or limit coverage under, or to rescind, the D&O coverage may lead to significant changes in litigation policies; and (2) the conduct of the litigants does not strategy. unnecessarily reduce the amount available to resolve the dispute. “The amount and scope of coverage may The conservator should be involved in the analysis lead to significant changes in litigation strate- of the D&O insurance coverage, statements to the gy.” financial press and to regulators, decisions on the scope and conduct of internal investigations, deci- For example, if the size of the D&O policy is small sions about whom should be sued, the drafting of compared to the damages sought, a review of the pleadings, the setting of discovery goals, the notify- policy may lead the securities plaintiffs to focus their ing of and reporting to insurers, and decisions on strategy on obtaining a recovery from the target settlement. company and/or the personal assets of the directors Because D&O insurance is at least a significant, and officers. if not always the key asset, available to pay for Second, if the insurers have significant coverage resolution of securities litigation, conscious regard defenses, a review of the policy may lead the securi- must be paid to it. It is better to make key litigation ties plaintiffs to likewise focus their strategy on decisions with D&O insurance in mind than to suffer obtaining a recovery from the target company and/or the potential consequence of not having it available the personal assets of the directors and officers. to resolve the litigation. Third, if the size of the policy is large and the insurers have few coverage defenses, securities B. Analyzing the Coverage plaintiffs may want to tailor their litigation strategy When events take place that may lead to a securi- to obtaining the policy proceeds alone, rather than ties fraud lawsuit and a claim under D&O policies, aggressively pursuing the personal assets of the it is important for the company and the directors and policyholders. officers to immediately review the insurance cover- Fourth, the presence of provisions enabling the age. Securities fraud plaintiff lawyers also are well insurers to rescind the D&O coverage may lead served by obtaining and reviewing the D&O policies securities plaintiffs to tone down allegations of intent as soon as possible — it will guide litigation and knowledge, and limit their search for admissions decisions. of such intent and knowledge in discovery to avoid An immediate review by D&O policyholders is giving the insurers ammunition for an attempt to necessary for several reasons. First, D&O policies avoid their duties under the policies. are claims made and reported policies — a claim Fifth, if the target company is solvent and is itself must be made and reported during the policy period covered under the D&O policies for securities in most cases for there to be coverage. Accordingly, claims, securities plaintiffs will want to carefully the D&O policies must be reviewed to give proper evaluate which and how many directors and officers notice to the insurers. The penalty for failing to to include as defendants. It may not be necessary to timely notify the insurer may well be forfeiture of sue all of the directors and officers in this situation the policy proceeds — whether or not the insurer and, by refraining from suing some defendants or has been prejudiced. 3 dismissing them from an ongoing suit, securities Second, D&O policies often have specific provi- plaintiffs may be preserving the D&O insurance sions limiting the policyholders’ choice of counsel proceeds by reducing the number of defense counsel. to those lawyers specifically listed in the policy. It may be prudent to limit the number of outside Decisions concerning the retention of counsel must directors sued. While including some outside direc- be made with these provisions in mind. Third, D&O tors may ensure the availability of D&O policy policies often require a policyholder to notify an proceeds (because outside directors can seldom be insurer concerning settlement offers and/or obtain its shown to have acted in a deliberately fraudulent consent before accepting such offers. Review of the manner), suing all outside directors may lead to an D&O policies is necessary to ensure that the D&O unnecessary depletion of those proceeds through policyholders are complying with its provisions in defense costs. connection with early potential settlements. C. Avoiding Statements and Conduct Harmful to Securities plaintiffs also have good reason to Coverage review the D&O policies of their corporate target, but may not have adequate access to those policies When events take place that may lead to a securities fraud lawsuit and a claim under a D&O initial investigation of a case to make certain that policy, it also is important for the company and the they do not engage in conduct that may lead to the directors and officers to keep their D&O insurance securities lawsuit not being covered under the D&O coverage squarely in mind when making subsequent policy. For example, D&O policies contain “insured public statements to the markets or to regulators. vs. insured” exclusions which bar coverage for share- This is seldom done. The natural desire on the part holder lawsuits that are assisted by an insured person. of companies to clean up any scent of wrongdoing Thus, plaintiffs’ lawyers should consider the effect often leads to an overreaction that may be unneces- of being assisted by directors and officers in investi- sarily harmful to coverage. Securities fraud plaintiff gating and preparing their complaints. lawyers’ also would be well served by keeping D&O coverage squarely in mind when investigating poten- D. Softening the Insurers’ Negotiation Position tial wrongdoing, making statements to the press, and asserting allegations in a complaint. As a securities fraud case progresses, the interests Under the Securities Exchange Act of 1934, direc- of the plaintiffs and defendants may become even tors, officers, and the company are liable only if the more aligned with respect to the insurance policy, person making misrepresentations acted with particularly as to insurers who have seriously ques- “scienter.” While scienter encompasses intentional tioned, denied, or are seeking to rescind coverage. nondisclosure with conscious knowledge of the non- In those situations, both the plaintiffs and the defen- disclosure — which insurers will argue is “deliberate dants will want to bring the maximum leverage to fraud” excluded by D&O policies, scienter also has bear upon insurers to reconsider their position. been held to encompass strong recklessness with D&O policies require an insurer to consent to any respect to disclosure accuracy. 4 settlement of an underlying securities action, but the In the wake of allegations of wrongdoing and/or insurer may not unreasonably withhold its consent in connection with restatements of financials, it is to a settlement. Absent a good faith reason for not unusual for a company to commission an internal refusing to consent to a settlement within policy investigation. It is important for a company to do limits, an insurer subjects itself to any liability above so, but it is equally important for the company and the policy limits if it rejects a policy limits settlement its independent counsel to consider the coverage demand. implications in commissioning and drafting the re- For example, in a case against primary and excess port. Similarly, if, in statements to the financial press D&O insurers, a federal court held (1) that the D&O and to regulators, the company points its finger at insurers were potentially liable for amounts in excess its insiders in connection with securities fraud allega- of their policy limits by refusing to accept a reason- tions, it should consider the coverage implications able settlement offer within policy limits; and (2) that of its statements. While it may at times be necessary those insurers were potentially liable for punitive to dismiss an employee based on violations of the damages sought by their D&O policyholders for securities law, it may not be necessary to assert that failing to do so. 6 There, the primary D&O insurer the conduct amounted to deliberately fraudulent had offered only $2 million to settle despite its own wrongdoing. claims examiner’s determination that the lawsuit had a settlement value of nearly $4 million and despite “But, securities plaintiffs should always keep its awareness that mock trials had evaluated damages D&O insurance in mind, and not attempt to at $11 to $30 million. 7 Similarly, the excess insurer allege and prove too much.” refused to contribute to settlement even though its monitoring counsel had opined that the settlement Similarly, securities plaintiffs should take care in value of the lawsuit was well within the excess structuring their allegations to avoid aiding an insur- insurers layer of coverage. 8 er’s attempt to rescind a D&O policy or exclude the Generally, to put an insurer at risk for extra- securities lawsuit based on the deliberate fraud ex- contractual damages, the securities fraud plaintiffs clusion. We all recognize that the Private Securities must make a firm demand for settlement within Litigation Reform Act of 1995 allows a court to policy limits. Then, the directors, officers, or the dismiss a securities actions unless the complaint company must demand that the insurers accept the “state[s] with particularity facts giving rise to a demand. The advantage is two-fold. First, it may strong inference that the defendant acted with the result in the insurers reevaluating their position and required state of mind.” 5 But, securities plaintiffs agreeing to settle the matter. Second, if the insurers should always keep D&O insurance in mind, and not refuse to settle, it may have sealed their potential attempt to allege and prove too much. liability for extra-contractual damages. As the case Securities plaintiffs also should take care in the progresses, the policyholders and the claimants may be able to bring additional pressure to bear on the In crafting the settlement agreement, care should insurer because of this increased exposure. be taken to specify that covered claims, covered persons, and covered loss are being settled. It may E. Crafting the Settlement be helpful to include recitations that the securities plaintiffs and D&O policyholders are resolving po- tential liabilities for misrepresentations allegedly “Care must be taken in crafting a settlement made with recklessness as opposed to misrepresenta- that both provides the policyholders the ‘peace’ tions made with intent or with conscious knowledge they require and allows the claimants the in- of the misrepresentations. surance proceeds they seek.” Care also should be taken with respect to what claims are being settled and with respect to which D&O policyholders and securities plaintiffs are defendants the claims are being settled. For example, sometimes confronted with an insurer that refuses some courts have held that “loss” under a directors to authorize the policyholder to accept a reasonable and officers insurance policy does not encompass the settlement offer or refuses to fund the settlement. In restoration of ill-gotten gain. If the insurers have this situation, the interests of the D&O policyholders raised this policy defense, the structure of settlement and the securities claimants become even more may be crucial to coverage. closely aligned against those of the insurer. Care For example, in Conseco, Inc. v. National Union must be taken in crafting a settlement that both Fire Ins. Co. of Pittsburgh, Pa., 11 Conseco and its provides the policyholders the “peace” they require directors and officers were sued for violations of and allows the claimants the insurance proceeds they Section 11 of the Securities Act of 1933. It was seek. alleged that Conseco took advantage of misrepresen- tations by selling its stock at an inflated price. The Typically, these settlements take the form of non- parties settled the case with Conseco agreeing to pay recourse settlements, allowing plaintiffs to recover approximately $82 million with respect to the Sec- only from the insurance proceeds. Non-recourse tion 11 violations. In the insurance coverage action settlements often make sense both for the D&O that followed, the court held that the settlement policyholders and the securities plaintiffs. The poli- payment did not constitute “loss” because the corpo- cyholders become free of the risk to their personal ration was just returning ill-gotten gain. The outcome assets. For their part, securities plaintiffs find such might have been avoided if the settlement agreement settlement agreements attractive because (1) they had required the directors and officers, rather than remove the risk of losing the securities fraud case; Conseco, to pay the $82 million for the Section 11 and (2) they remove the risk that by winning the violations because a payment by the directors and securities fraud case, the plaintiffs may furnish the officers would not have constituted disgorgement of insurers substantial arguments for avoiding coverage. ill-gotten gain. Faced with claims by securities plaintiffs under a non-recourse settlement, the insurer will not be IV. Conclusion allowed to litigate whether the directors, officers, and The nature of D&O insurance and securities fraud the company were actually liable or even whether litigation produces strange bedfellows: claimants, their fraud voids the D&O policies. Rather, the directors, officers, and the company. All have a insurers may be limited to defending on whether the common interest in preserving and conserving D&O settlement was made in reasonable anticipation of policy proceeds to pay for resolution of the dispute. potential liability and was reasonable under the cir- When the availability of D&O insurance to cover a cumstances. 9 claim is questioned by insurers, the interest of the Although insurers can be expected to argue that claimants become closely aligned with that of the a non-recourse settlement is not covered under D&O D&O policyholders. Conservation of D&O insurance policies because the directors, officers, and the coverage becomes an important common point of company are not “legally obligated to pay” as re- interest for both securities claimants and defendant quired by D&O policies, substantial authority exists insureds, who should guide their respective litigation that such settlements are enforceable. 10 tactics accordingly.

1 But see, e.g., Alstrin v. St. Paul Mercury Ins. Co., 179 F. Supp. 2d 376, 395-96 (D. Del. 2002)(rejecting insurers’ argument because such a reading of the exclusion makes illusory the coverage provided by D&O insurance). 2 See B. Black, B. Cheffins, and M. Klausner, Outside Director Liability, Working Paper No. 250, Social Science Research Network (http://papers.ssrn.com/ abstract382422) (providing an excellent discussion of settlement dynamics in securities and derivative litigation). 3 See, e.g., Federal Ins. Co. v. CompUSA, Inc., 319 F.3d 746 (5th Cir. 2003) (holding D&O policyholders forfeited coverage for a $265 million judgment by failing to timely notify insurer of a claim). 4 See, e.g., Section 10(b); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12 (1976) (presaging issue); J.H. Cohn & Co. v. American Appraisal Assoc., 628 F.2d 994 (7th Cir. 1980). Notably, even insurers have admitted that scienter of this type is not excluded by D&O insurance policies. Alstrin v. St. Paul Mercury Ins. Co., 179 F. Supp. 2d 376, 396 (D. Del. 2002). 5 Securities Exchange Act of 1934 § 21D(b)(2)-(3). 6 See Vicorp Restaurants, Inc. v. Federal Ins. Co., No. 92-C-751, 1993 U.S. Dist. LEXIS 20294 (D. Colo., 1993). 7 See Vicorp Restaurants, Inc. v. Federal Ins. Co., No. 92-C-751, 1993 U.S. Dist. LEXIS 20294 (D. Colo., 1993). 8 See Vicorp Restaurants, Inc. v. Federal Ins. Co., No. 92-C-751, 1993 U.S. Dist. LEXIS 20294 (D. Colo., 1993). 9 See, e.g., WestAmerica Mortgage Co. v. Tri-County Reports, Inc., 670 F. Supp. 819, 822 (N.D. Ill. 1987). 10 See, e.g., FDIC v. Gordiner,783 F. Supp. 1186 (D. Minn.), rev’d on other grounds, FDIC v. St. Paul Fire & Marine Ins. Co., 993 F.2d 155 (8th Cir. 1993); Bishop v. Crowther, 428 N.E.2d 1021 (Ill. App. 1981); Miller v. Shugart, 316 N.W.2d 729 (Minn. 1982). 11 Conseco, Inc. v. National Union Fire Ins. Co. of Pittsburgh, Pa., 2002 U.S. Dist. LEXIS 26554 (Ind. Cir. Ct. Dec. 31, 2002).