Recent cases have highlighted pitfalls in the way claims against companies and their officers and directors can be settled that impact coverage under D&O policies. The failure to appreciate the effect of settlements on coverage matters can result in the loss of coverage just when the matter is being concluded, an unfortunate and costly consequence for unaware policyholders. These pitfalls can almost always be avoided by giving prompt consideration to potential D&O coverage issues, long before entering into any settlement, and then revisiting the D&O policies before settlement negotiations begin.
"Disgorgement" is not covered
Disgorgement is a remedy requiring a wrongdoer to return the benefits wrongfully received from another. Claims for disgorgement are viewed as uninsurable both as a matter of common law or public policy and because the specific language in D&O policies typically excludes coverage for losses resulting from the acquisition of an improper benefit. A recent New York case reinforced that rule, finding that any damages denominated "disgorgement" were not recoverable from the D&O carrier.
In J. P. Morgan Securities, Inc. v. Vigilant Ins. Co., the U.S. Securities and Exchange Commission (SEC) charged Bear Stearns & Co. with facilitating late trading and market timing for certain customers.1 The profits from these activities went to Bear Stearns' clients; Bear Stearns itself said it generated only $16.9 million in revenue from the activities.
Bear Stearns ultimately entered into an agreed order with the SEC pursuant to which it would pay $160 million attributed to the benefits its clients had received and $90 million in penalties. Bear Stearns neither admitted nor denied liability.2 Bear Stearns then sought to be indemnified by its D&O insurers for the $160 million payment.3
Unfortunately for Bear Stearns (and its successors), the $160 million was described in the SEC order as "disgorgement." The court had no trouble concluding that, under New York law, disgorgement was not insurable.4 In response to Bear Stearns' objection that it did not actually "disgorge" $160 million because it had not received $160 million in benefits, the court found that the SEC was not required to itemize or trace the proceeds of any wrongful benefit, implying that the $160 million was a rough approximation of the benefit Bear Stearns had received.5 The court also noted that "collaborating" parties could be held jointly and severally liable for wrongfully received benefits.6
Regardless of the court's reasoning, one conclusion to draw from the case is that Bear Stearns lost its ability to recover proceeds for its SEC settlement when it agreed to the characterization of the settlement payments as "disgorgement." A more accurate description of the settlement amounts may have resulted in a more beneficial outcome for the policyholder.
Covenants not to execute prevent an insurable "Loss"
Policyholders frequently try to settle claims against them by entering into agreed judgments coupled with covenants not to execute against any of their assets other than insurance coverage. Whether that strategy can succeed in the D&O context depends on the specific definition of "Loss" in the policy and the applicable state's law.
In U.S. Bank Nat'l Ass'n v. Federal Ins. Co., claims against former officers of Interstate Bakeries, Inc., which had gone bankrupt, were assigned by court order to a creditors' trust.7 The creditors' trust agreed, with court approval, to seek satisfaction of any claims only from Interstate's D&O policies and not from the officers' personal assets. The creditors' trust then sued an Interstate officer, who tendered defense to Federal, which denied coverage for a number of reasons. The officer then settled the claims with the creditors' trust for $56 million, to be satisfied only from the D&O policies.
The applicable policy language limited coverage to "Loss for which ... the Insured Person becomes legally obligated to pay." The Eight Circuit noted a split in courts as to whether amounts covered by an agreement not to execute are subject to a "legal obligation to pay." The court did not resolve that split, however, noting that the policy language additionally excluded from "Loss" all amounts "for which the Insured Person is absolved from payment by reason of any ... agreement." The court ruled that the agreement not to execute in fact "absolved" the officer from payment of the settlement amount.8 In so concluding, the court rejected arguments that the officer had sustained real consequences from the agreed judgment, including stigma and the risk of increased insurance premiums in the future, noting that the policy language excluded coverage if the officer was absolved from "payment," not from "consequences."9
As a result, Interstate Bakeries' creditors are left with an unenforceable $56 million judgment. This result will complicate the future efforts of insured directors and officers to settle claims against them without exposing themselves to potential personal liability. The lesson in this case is the need for policyholders and their brokers to scrutinize proposed policy language before inception to try to avoid the kind of limiting language found dispositive in this case.
Settling with the primary carrier may limit the ability to tap excess layers
Policyholders continue to learn the hard way that they have lost their ability to obtain coverage from excess insurers because their settlements with primary carriers did not "exhaust" the primary layers of coverage. Before settling with any insurer, policyholders need to know precisely what each of their excess policies states about exhaustion and how that language will be applied in the relevant jurisdiction.
In Goodyear Tire & Rubber Co. v. National Union Fire Ins. Co. of Pittsburgh, Pa., Goodyear Tire & Rubber Co. was left exposed to $20 million of legal and accounting costs incurred in defending securities class actions, derivative lawsuits, and an SEC investigation.10 Goodyear had settled with the carrier on the primary $15 million layer for $10 million before pursuing the excess carriers. The excess policy coverage, however, attached only "after the insurers of the underlying insurance shall have paid in legal currency the full amount of the underlying limit." Goodyear argued that the plain language of the exhaustion requirement should not be enforced, because of the strong state policy favoring settlements and because the excess carriers were not prejudiced in any respect because they would be liable for no more than they would have been if the primary policy limits had been fully paid.
The court rejected both of Goodyear's arguments. First, it found that the state policy favoring settlements was trumped by "the equally potent interest in fostering freedom of contract and holding parties to the agreements they make."11 In reaching this conclusion, the court distinguished the clear language used by the D&O polices at issue from the more ambivalent language it found in other insurance contexts. Second, it found that the excess carriers were prejudiced by the mere fact of having to litigate whether the underlying policy limits were exhausted by a less-than-the-limits settlement. Moreover, the court noted that excess insurers base their calculation of premiums on the expectation that their coverage will not attach until and unless there has been full payment of the underlying limits.12 Third, the court found that Goodyear had a high degree of sophistication and could have shopped around for more favorable exhaustion language. The court therefore granted summary judgment to the excess carriers and left Goodyear exposed to the remaining costs.
Carriers have the right to "associate" with any settlement
D&O policies typically grant carriers the right to associate with the defense of any action and require carrier consent to any settlement. The time pressures of litigation often result in policyholders neglecting those policy terms, inadvertently risking the loss of the coverage they expected. A recent case illustrates both the perils facing policyholders and the lengths courts will go to protect them.
In MBIA Inc. v. Federal Ins. Co., MBIA, Inc., received the first of several SEC and state attorney general subpoenas in November 2004.13 In September 2005, MBIA sought consent from its D&O insurers to settle potential SEC and AG charges for approximately $75 million. The carriers consented to MBIA's pursuit of settlement discussions. By the end of 2006, MBIA had reached an agreement to pay the regulators $75 million. In addition to the monetary payments, the settlements also required MBIA to retain an independent consultant to investigate certain transactions.
The carriers refused to cover the costs of the independent consultant, claiming they had not been timely advised of the requirement and had not consented to it. The district court agreed, finding that the policyholders had breached the carriers' "right to associate" with the defense and settlement of the claim by agreeing to the independent consultant terms without the carriers' approval.
The Second Circuit reversed, finding that MBIA satisfied its obligations under the policy by providing notice of the claims involved in the settlement discussions "early enough in the process to allow the insurers to exercise their option to associate effectively."14 Although the policyholders failed to provide the carriers with prior notice of the requirement for an independent consultant, the court found that requirement "grew out of the natural course of settlement discussions about the same claim in which the insurers could have participated all along."15 Moreover, the court found that the carriers should have realized that review by independent consultants are "not a rare" component of regulatory settlements. The court therefore reversed the ruling of the district court and ordered entry of summary judgment for MBIA.
Although MBIA was ultimately successful in obtaining full coverage for its settlement obligations, it could have reached this same result with significantly less effort with more timely communications with its carriers. D&O policyholders need to keep their carriers sufficiently informed of the status of settlement negotiations so that carriers cannot legitimately claim to be surprised by the result of those negotiations.
Conclusion
As the above examples illustrate, policyholders who put off thinking about insurance coverage until after settlement may find an unhappy surprise. They may find that they — not their D&O carrier — have to fund the settlement because of mistakes made in the settlement process. But with careful lawyering and timely consideration of coverage issues — before, not after settlement negotiations — these pitfalls can be avoided and coverage can be maximized.
Footnotes
1 936 N.Y.S.2d 102 (N.Y. App. Div. 2011).
2 Thus, there had arguably not been a final adjudication required to support a wrongful conduct exclusion.
3 Although not clear from the opinion, the $90 million in penalties were likely expressly excluded from coverage.
4 Id. at 105.
5 Id. at 107.
6 Id.
7 664 F.3d 693 (8th Cir. 2011).
8 Id. at 698.
9 Id. at 699.
10 No. 08-cv-1789, 2011 WL 5024823 (N.D. Ohio Sept. 19, 2011).
11 Id. at * 3.
12 Id. at * 4.
13 652 F.3d 152 (2d Cir. 2011).
14 Id. at 168.
15 Id.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
