United States: SDNY Rules SEC Investigation Is A "Claim" Within Pending And Prior Acts Exclusion

The U.S. District Court for the Southern District of New York has held that a long-running investigation by the SEC constituted a "Claim" triggering the pending and prior claims exclusion in an excess directors and officers ("D&O") policy. See Patriarch Partners, LLC v. AXIS Ins. Co., No. 16-cv-2277 (VEC) (S.D.N.Y. Sept. 22, 2017).

This case stems from a high-profile SEC investigation into plaintiff Patriarch Partners, LLC ("Patriarch") relating to certain Patriarch investments known as the "Zohar funds." When the investigation began in December 2009, the SEC had referred to it as only an "informal inquiry" concerning certain unspecified Patriarch investments. In May 2011, however, the SEC started issuing more detailed requests for information pursuant to what it then referred to as an "informal investigation." At this time, the SEC began targeting the Zohar funds.

During the same period, the SEC began seeking documents from Patriarch executive, Meric Topbas, pursuant to an SEC formal order of investigation (the "Formal Order").The Formal Order authorized the SEC to issue and enforce subpoenas relating to the Zohar funds, and to collect evidence of fraud and a "possible violation" of the securities laws. Pursuant to the Formal Order, the SEC issued a subpoena to Topbas seeking all documents in his possession regarding the Zohar funds (the "Topbas Subpoena").

The AXIS Policy and the Denial

At the time the SEC investigation began escalating, Patriarch's insurance program included a primary D&O policy issued by Continental Casualty Company (CNA), and an excess D&O policy issued by defendant, AXIS Insurance Company (AXIS). Although the AXIS policy was "bound" on August 12, 2011, the complete policy was not issued until March 2012.

The AXIS policy followed form to and generally incorporated the terms and conditions of the CNA policy. The CNA policy defined a "Claim" as including "a written demand for monetary damages or non-monetary relief" or an "Investigation of an Insured alleging a Wrongful Act." "Investigation" was defined as including "an order of investigation or other investigation by the [SEC]," and "Wrongful Act" was defined as including "any actual or alleged violation of any ... federal ... rule or regulation..."

Although Patriarch did not have the full policy when coverage incepted in August 2011, the AXIS binder contained an endorsement providing that the full policy will exclude pending and prior claims, stating: "Pending & Prior Claim Date Endorsement – At Inception."

In March 2012, Patriarch's broker tendered coverage for the investigation to Patriarch's insurers, including CNA and AXIS. CNA accepted coverage, while AXIS reserved rights. Once the CNA policy had been exhausted, Patriarch demanded that AXIS defend it in connection with the SEC investigation. AXIS denied all coverage on September 11, 2015, prompting litigation.

The SEC Investigation Is a Pending and Prior "Claim"

The sole question before the court was whether the SEC investigation had become a "Claim" on or before August 11, 2011, so as to fall within the pending and prior claims exclusion. At the outset, the court clarified that the AXIS binder was the operative agreement for purposes of AXIS' motion because Patriarch's claim was made before the full AXIS policy was issued. Noting that binders are not integrated contracts, the court considered extrinsic evidence to resolve the parties' dispute as to the date from which the exclusion applied: August 11, 2011, or July 31, 2011, as AXIS contended. Construing the endorsement narrowly in favor of Patriarch, the court held that any claim against Patriarch is excluded if it was pending when AXIS' coverage incepted on August 11, 2011. Even then, however, the court held that the exclusion still precluded coverage for the SEC investigation.

Specifically, the court found that the Topbas Subpoena, the Formal Order, and the SEC's underlying investigation were all "Claims" pending on or before August 11, 2011.

First, the court held that the Topbas Subpoena was a "demand" for "non-monetary relief" under the CNA policy. The court emphasized that "an SEC subpoena is not a mere request for information, but a substantial demand for compliance by a federal agency," that the SEC is authorized to enforce its subpoena power, and that the Topbas Subpoena "makes quite clear that compliance is not optional..." The court also observed that other courts have consistently found "non-monetary relief" to include situations where, as here, the insured is required to produce documents.

In so holding, the court found that the CNA policy was distinguishable from the policy at issue in Diamond Glass Companies, Inc. v. Twin City Fire Ins. Co., 2008 WL 4613170, at *2 (S.D.N.Y. Aug. 18, 2008), upon which Patriarch heavily relied. In Diamond Glass, the court held that a grand jury documents subpoena was not a "Claim" (i.e., a "demand" for "non-monetary relief") because, in the context of that case, the parties did not intend for coverage to apply unless there was an assertion of civil or criminal liability against the insured. Here, the court emphasized that the CNA policy was not limited in that regard. Had the parties only intended to exclude "Claims" where there was an assertion of civil or criminal liability, the court stated that "they could have done so by limiting coverage to demands for non-monetary relief that allege a 'Wrongful Act.'" Indeed, the court observed that the CNA policy "contains precisely this limitation with respect to coverage of 'Investigations' but does not include any similar limit in coverage for 'demands' for 'non-monetary relief.'" Thus, the court concluded that the Topbas Subpoena was a "Claim" within the pending or prior acts exclusion.

Jointly considering the Formal Order and the SEC's underlying investigation, the court held that each is also an excluded "Claim." The court first noted that the definition of "Investigation" in the CNA policy explicitly references "an order of Investigation or other Investigation by the [SEC]." The court also highlighted a statement in the Formal Order that information "tends to show" that Patriarch "may have been or may be" engaging in securities fraud. The court held that this statement, combined with the "escalating seriousness" of the SEC's inquiry, supported the conclusion that the SEC was conducting an "Investigation" of an alleged "Wrongful Act" so as to fall entirely within the pending or prior acts exclusion.

This case reflects the importance of contract negotiating and drafting. It is also interesting because unlike cases where the policyholder is trying to prove that an SEC investigation is a "Claim" so as to trigger the insuring agreement, here, Patriarch argued that the investigation was not a "Claim" in order to sidestep an exclusion.

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