By: Gregory S. Wright
I. Introduction
In 2007, the subprime mortgage crisis triggered a wave of litigation and regulatory action involving not only the lenders that sold subprime mortgages, but also the issuers, underwriters, and other financial institutions that participated in the securitization of the mortgages and the sale of securities backed by the subprime loans. The credit crisis of the last few months has exacerbated (and likely will continue to exacerbate) this wave of litigation and regulatory action, not only by increasing the number of claims, but also by expanding the universe of targets to include companies and individuals that were not directly involved in the sale or securitization of subprime loans.
Given this expanding crisis, many corporations (as well as their officers and directors) will be forced to incur substantial sums to defend such claims, to settle such claims, and/or to pay judgments. In many cases, insured companies and their officers and directors should be entitled to coverage for such costs under their Directors’ and Officers’ (“D&O”) liability policies. While this article focuses on D&O coverage, policyholders also should consider the potential for coverage under other policies, such as Errors and Omissions liability policies and Fiduciary liability policies.
It should be noted that the terms of D&O policies vary widely. In addition, one should assume that insurers will assert all available defenses to such claims based on the specific policy language and facts at issue. Given the potential for coverage, policyholders facing claims and investigations should carefully review their D&O policies and should take appropriate steps in order to maximize their potential insurance recoveries.
II. Credit Crisis Litigation and Investigations
The subprime mortgage crisis, and the ensuing credit crisis, has produced a wide array of claims, lawsuits, and government investigations. Companies and individuals in a rapidly expanding list of industries have been impacted. Many of the claims at issue target individuals who are commonly insured under D&O policies (e.g., individual directors and officers), as well as the target entity itself, and allege conduct that often potentially triggers coverage under D&O policies, such as alleged misstatements in public filings, negligent misrepresentations, and/or breaches of fiduciary duties. Merely to illustrate, this wave of litigation and investigations includes the following types of current claims, all of which potentially may trigger coverage under D&O policies:
- Lawsuits by shareholders against lenders and certain directors and officers alleging (in part) that defendants made false and misleading statements to the public about subprime lending activities.
- Lawsuits by shareholders against investment banks and certain directors and officers alleging misstatements about the value of and risks associated with subprime-backed assets.
- Lawsuits by investors against financial institutions and certain directors and officers alleging that the defendants that sold them mortgage-backed securities misrepresented the risks associated with such securities.
- Class action lawsuits against failed banks, related holding companies, and related officers and directors, alleging that the defendants misled investors about the financial status of the bank, violated securities laws, committed fraud, made negligent misrepresentations, etc.
- Class action lawsuit on behalf of preferred shareholders of Fannie Mae and Lehman Brothers alleging false statements by named officers and directors in connection with the offerings.
- Class action lawsuits against companies not directly involved in the subprime area (such as Constellation Energy), as well as their directors and officers, alleging failure to make appropriate disclosures about exposures arising from credit problems of trading partners (e.g., Lehman Brothers).
- Class action lawsuits and regulatory investigations against companies concerning auction rate securities. The lawsuits allege in general that the companies failed to make appropriate disclosures about the risks associated with auction rate securities. Some (but not all) of the lawsuits name individual directors and officers. While most of the lawsuits have been filed on behalf of the purchasers of the auction rate securities, at least one lawsuit was filed on behalf of shareholders of the entity (Merrill Lynch) that sold the auction rate securities to other investors. See also M. King, SEC and FINRA Focusing on Individuals in Auction Rate Securities Investigation, available here.
- SEC investigations into possible market manipulation in connection with short selling in the securities of financial institutions. See B. Ochs, Manipulation Tied to Short Selling a Top Enforcement Priority, available here.
- FBI and DOJ criminal investigations regarding accounting, disclosure, and corporate governance matters. See M. Ricciuti, DOJ Opens Criminal Investigations under New Guidelines for Prosecuting Corporate Entities, available here.
III. Potential Coverage under D&O Policies
In general, D&O policies afford coverage for “Claims” against an “Insured” alleging “Wrongful Acts” that result in a covered “Loss.” The availability of coverage turns on the definitions of such terms (which vary widely), other policy terms and conditions, and the nature of the specific allegations in the claim at issue.
Claim. D&O policies generally afford coverage for “claims.” All (or virtually all) D&O policies include “lawsuits” within the definition of “claim,” but coverage for regulatory or criminal investigations varies widely. For example, certain D&O policies define “claim” to include SEC investigations commenced by the service of a subpoena on an insured person or criminal proceedings commenced by the return of an indictment, information, or similar document. Other D&O policies cover a broader array of informal investigations, while other policies limit coverage to investigations commenced by a “formal order” of investigation. In any event, given the broad array of policy language available in the market, insureds should not wait for lawsuits to be filed before analyzing the potential for coverage.
Entity Coverage. In addition to covering claims against insured directors and officers, many D&O policies afford coverage for claims against the insured entity itself (for example, many D&O policies cover so-called “Securities Claims” filed against the insured entity, including class action securities lawsuits). The inclusion of “entity coverage” in D&O policies often helps insurers and policyholders avoid disputes on how to allocate defense costs and/or settlement payments among covered individuals and the entity itself.
Loss. The definition of “loss” in D&O policies varies widely. For example, some policies expressly cover fines, penalties, multiplied damages, and punitive damages, when permitted by law. Some D&O policies do not. In addition, insurers and policyholders frequently litigate (and courts recently have reached conflicting opinions on) the availability of coverage for so-called “disgorgement,” “restitution,” and/or for losses paid pursuant to Section 11 of the Securities Act of 1933. See, e.g., Bank of America Corp. v. SR International Business Ins. Co., 2007 WL 4480057 (N.C. Super. 2007) (holding that settlement of Section 11 claim may be covered under D&O policy).
Conduct Exclusions. Insurers also may seek to rely on various exclusions in the relevant policy to deny coverage for subprime-related claims. For example, insurers may seek to rely on so-called conduct exclusions, which bar coverage for certain claims relating to criminal or fraudulent activity or for claims alleging that the insured received a profit to which he or she was not legally entitled. Again, it should be noted that the terms of these exclusions vary widely. Some exclusions arguably bar coverage when the excluded conduct is merely alleged. However, in most policies, the exclusions do not apply unless the insurer meets its burden of proving that the excluded conduct “in fact” occurred or unless the excluded conduct is established via a “final adjudication.” When the policy at issue includes the “in fact” test or “final adjudication” test, insureds are often entitled to coverage for defense costs and/or settlements that are made without any finding or admission with respect to the excluded conduct. In addition, many D&O policies contain severability provisions that prevent the insurer from imputing the knowledge or conduct of one insured to other insureds, which in effect preserves coverage for the “innocent insureds” and/or the company itself.
Defense Issues. In many D&O policies, the insurer is not obligated to defend a claim, but rather is required to reimburse the policyholder’s defense costs. Nevertheless, certain D&O policies state that the policyholder should not incur defense costs or settle a claim without the consent of the insurer. In addition, certain D&O policies require the policyholder to obtain the insurer’s consent with respect to the selection of defense counsel (such consent not to be unreasonably withheld). To avoid potential insurer defenses, policyholders may wish to consider taking steps to address any conditions in the policy related to defense and/or cooperation with the insurer.
Rescission Issues. In response to claims alleging misleading statements in a public filing, insurers often attempt to rescind the policy at issue entirely to the extent the public filing at issue was attached to or incorporated by reference into the insured’s “application” for coverage. State law on this defense varies widely, but most courts impose a high burden of proof on insurers to demonstrate (among other things) that the alleged misrepresentation was material and that the insurer in fact relied on the alleged misrepresentation when it decided to issue the policy. In addition, many current D&O policies make coverage non-rescindable for certain types of claims or certain insureds. Further, many D&O policies contain strict severability clauses that limit the insurer’s right to rescind to only those individuals that had specific knowledge of the misstated facts.
Renewal Issues. As noted above, the terms of D&O policies vary widely. Further, insureds and insurers frequently negotiate certain terms of coverage during the renewal process. With proper planning, insureds potentially may obtain coverage-enhancing changes to standard policy forms that may be outcome-determinative when a claim is filed. Insureds frequently retain outside coverage counsel to review their D&O policies and participate in this renewal process.
IV. Conclusion
D&O policies offer a potentially valuable resource for policyholders facing claims arising from the subprime crisis and related credit crisis. Policyholders should take steps now to preserve their rights to coverage.
