The D&O E&O Monitor - Monitoring Issues and Trends in Directors & Officers and Errors & Omissions Liability and Coverage.

I am asked this question many times by claims, underwriting and brokerage clients and, dependent upon at what point in history the question is asked dating back to the passage of the Private Securities Litigation Reform Act (PSLRA) in December 1995, my answer varies. A somewhat typical “life span” range would be two to five years.

While admittedly an outlier, a recent decision of the United States District Court for the District of Arizona granting class certification and appointing a union pension fund as lead plaintiff, illustrates just how long a securities class action can last from first filing to final disposition. Siracusano vs. Matrixx Initiatives, Inc., No. CV 04-00886-PHX-NVW (Order of February 27, 2012).

You might recall this is the same case that previously wound its way to the Supreme Court of the United States on a pleading issue after the same court in Arizona had granted defendants’ motion to dismiss. Specifically, the case concerned the drug Zicam manufactured by the defendant and allegations that Matrixx concealed reports that the drug could cause anosmia, a loss of the sense of smell.

The Supreme Court ruled that any adverse event reports concerning Zicam that alter the “total mix” of information otherwise disclosed or available to the market, also had to be disclosed. The Court remanded the case to the District Court for further proceedings consistent with its ruling. Matrixx had argued that only “statistically significant” studies or reports must be disclosed.

This case was commenced in the District of Arizona by filing of a Complaint on April 27, 2004, so it is now approaching its eight-year anniversary. Although I am not privy to any details of the litigation, including the limits of any tower of D&O insurance for Matrixx, one can easily imagine defense and appellate expenses already totaling at the seven- or eight-figure levels.

What could lie down the road in the Matrixx litigation?

With dismissal and class certification already ruled upon in favor of the plaintiff class, discovery should now begin in earnest. It may in fact have already begun after the Supreme Court decision in March 2011 and subsequent remand to the trial court. It is also possible that at some point during or after discovery defendants could move for summary judgment. Ultimately, there could be a trial on the merits or appeals from any summary judgment or trial judgment ruling. Of course, it is always possible, if not likely, that the litigation will settle at some point through direct negotiations or facilitated by mediation.

Given all of these possibilities, it is not entirely out of the realm of reasonable conjecture that this case will reach its 10th anniversary, and possibly extend beyond that point.

CONCLUSION:  An underwriter’s and actuary’s nightmare.

On July 1, 2011, the Second Circuit issued its much awaited, and now sure to be controversial among insurers, decision and opinion in MBIA, Inc. v. Federal Ins. Co. and ACE American Ins. Co., No. 10-0355 (2d Cir., July 1, 2011). The Court’s decision was fully favorable to the insured, MBIA, with respect to coverage under the policies for (i) costs incurred in response to a subpoena from the New York Attorney General (“the AG”), (ii) voluntarily incurred costs in response to informal requests from the Securities Exchange Commission (“SEC”) and the AG, (iii) costs of independent consultants retained to conduct investigations in connection with settlements with the SEC and the AG, and (iv) costs incurred by a Special Litigation Committee (“SLC”) formed to investigate allegations of wrongdoing on the part of MBIA directors and/or officers set forth in shareholder derivative litigation. We will analyze the full impact of the decision in our next issue of the Specialty Lines Advisory, but the focus in this post will be confined to the issue of coverage for the SLC costs.

The policies at issue were two D&O policies – one a primary D&O policy in the amount of $15M issued by Federal; the other a $15M excess policy issued by ACE. Of pertinence to the Court’s ruling was the fact that the Federal policy provided a $200K sublimit for investigative costs related to a shareholder derivative demand.

Prior to the filing of the shareholder derivative litigation, MBIA received demand letters from the soon-to-be shareholder plaintiffs asking the MBIA board to bring suit against certain directors and officers for alleged breaches of fiduciary duty and other wrongful acts. MBIA formed a Demand Investigative Committee (“DIC”) in response. Such committees are often also called Special Investigative Committees or simply Investigative Committees. In any event, the DIC did not take timely action and shareholder derivative action followed. MBIA then organized a SLC in response to the litigation and, after the SLC completed its investigation, it (the SLC) concluded that maintaining the derivative suits was not in MBIA’s interests and the litigation should be dismissed. The litigation was in fact thereafter dismissed.

The Court found that the costs incurred by the SLC were covered essentially because it was an “Insured Person” under the policy formed by MBIA pursuant to applicable Connecticut corporate law. Although the Court did not elaborate, it is presumed that the SLC was determined to be an “Insured Person” rather than an insured entity because it was composed solely of various independent directors of MBIA.

The controversial aspect of the Court’s ruling on this issue, in my opinion, lies not so much in determining whether or not the SLC’s interests were congruent with those of MBIA. That should not have been the issue in light of the fact that MBIA was simply a nominal defendant in the derivative litigation. As such, there were no “claims” made against MBIA and its interests were arguably aligned with those of the derivative plaintiffs to a certain extent. Indeed, that is what gives MBIA the power and ability to ultimately have the litigation dismissed.

What the Court did not do, unfortunately, is examine this coverage issue as it should have been from the perspective of the insured defendants, i.e., MBIA’s directors and officers. They are the insured parties against whom a claim is asserted. While the SLC investigation ultimately succeeded in having the litigation dismissed, that was not the purpose of the SLC. If anything, the SLC was adverse to the interests of the defendant directors and officers, particularly because the SLC might, at the conclusion of its investigation, recommend that MBIA assume a vigorous, direct prosecution of the claims asserted derivatively on its behalf. Thus, the costs incurred were not at all covered defense expenses under the policy, even if they were arguably incurred on behalf of the insured MBIA. MBIA, as nominal defendant, did not require a defense in derivative litigation; only do the defendant directors and officers. The fact that the work of the SLC may have incidentally benefitted the directors and officers at the end of the day, should not be the test for determining whether these costs are covered.

The insurers also argued alternatively that, if the SLC expenses were covered, they should nonetheless be subject to the $200,000 sublimit for shareholder demand investigations. The Court, however, held that the sublimit would only apply to the pre-litigation costs incurred by the DIC and not to the litigation-related costs of the SLC. Left unanswered is whether the costs of a DIC would be covered at all in the absence of such sub-limited coverage grant. It would appear that this Court would have applied the same reasoning as it did to the SLC costs.

Barring a petition for rehearing en banc and/or the even more remote possibility of successfully seeking certiorari for an appeal to the Supreme Court, this ruling would appear to be final. While it arguably is confined to simply the Second Circuit’s interpretation and application of Connecticut law, the decision will likely have important ramifications in the D&O insurance community. Brokers will no doubt strive to be sure that policy language unequivocally covers SLC cost and is in no way sub-limited.* Further, given continuing soft market conditions, it is doubtful that insurers can effectively refine or clarify policy language to more effectively extend the application of the investigation demand sub limits to ensuing derivative litigation.

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*Typical sub limits for this type of coverage rarely exceed the level of $250,000. Such amount will not cover completely the costs of a SLC in most instances, which are commonly at levels of at least seven figures.

At least that is what Steven M. Davidoff appears to suggest to directors and officers in an article appearing in The New York Times on June 7, 2011.

The article has stirred up a bit of a tempest in insurance and legal circles, and it is still too soon to conclude whether or not such will be confined to the proverbial teapot.

From my perspective as counsel to D&O insurers, I agree with much of what Davidoff said in his piece, but I do want to share some additional observations.

Davidoff’s article gives the implication that personal liability for these individuals is rare. Au contraire, the personal liability is very real and frequently imposed or at least threatened. The actual payment responsibility for this liability, however, is often successfully passed back to the corporation by way of an indemnification provision in the corporate by-laws or else directly to a D&O insurer.

Since the mid to late 1980s, the scope of permissible corporate indemnification greatly expanded in Delaware and virtually all other states. Thus, there should always be corporate indemnification available without any monetary limit or cap except in the following circumstances.

• The corporation becomes financially insolvent. Indeed, this is one of the principal reasons to assure that the corporation procures ample limits of insurance to protect its directors and officers, including separate limits available to the independent directors only.
• There is some legal prohibition against indemnification. These instances are rare and generally limited to situations such as very egregious conduct by the director or officer, disgorgement of ill-gotten gain, and breach of the duty of loyalty to the corporation. One notable exception in most states, however, lies in a settlement or judgment amount in a shareholder derivative action alleging mismanagement and breaches of fiduciary duty to the corporation. Again, the backstop here is the D&O insurance policy.

While insurance is the backstop when indemnification fails, the following should nonetheless be noted.

• Insurance policies have finite limits of liability and the exposures can exceed those limits, particularly when legal defense costs are considered.
• An insurance policy is not a financial guaranty. Policies have exclusions and other limitations that may result in a loss becoming wholly or partially not covered.
• Egregious conduct that may result in disgorgement of ill-gotten gain is often not covered under insurance contracts or uninsurable as a matter of law, as well as being outside the scope of permissible indemnification.

One of the comments online that followed the Davidoff article noted the possibility of unpaid corporate tax liabilities of officers after a company becomes insolvent. Yes, indemnification is no practical remedy there, but a few D&O insurance policies are now being endorsed to provide that coverage. When it comes to disgorgement of ill-gotten gain, directors and officers receive little sympathy from this quarter. Why should the corporation or insurers pay for what you should not have had in the first instance?

The bottom line is that the legal liability for directors and officers is very real but, given the prevalence of liberal indemnification and broad coverage under D&O policies, the financial exposure or consequences are relatively small and/or infrequent.

Thus, if there are any corporations with an independent director opening, I am ready, willing and able to serve. I will, however, give careful scrutiny to your indemnification provisions and D&O insurance structure.

One of the finest sources of useful and practical information about D&O, E&O and professional liability policies – among other insurance and risk management topics – is the International Risk Management Institute (“IRMI”).* I particularly enjoy their D&O MAPS updates (paid subscription required) prepared periodically by Bob Bregman. A recent update on April 29 contained the “D&O Practice Tip” column entitled Improve Bankruptcy Carve-Back of the Insured versus Insured Exclusion.

It should be noted that what used to be a much broader insured versus insured exclusion has today evolved in most policy forms or by way of endorsement into an entity vs. insured exclusion, i.e. one which will preclude coverage for any claim brought by or on behalf of an entity insured under the policy against any other insured entity or an insured person. This has eliminated the need for many carve-backs, but a few key ones remain for the protection of the insureds such as for claims brought by any bankruptcy trustee, receiver, liquidator, conservator, rehabilitator or similar official or legal entity. While an argument can be made that any claim brought by a committee of secured or unsecured creditors is not within the scope of the exclusion, the column wisely suggests that it would not hurt to add these committees to the bankruptcy carve-back.

The column suggests that an ideal carve-back to the exclusion from the insureds’ perspective might read as follows:

            This exclusion does not apply to 

1. a Claim by the Examiner, Trustee, Receiver, Liquidator, or similar official appointed for the Insured Organization (or any assignee thereof),
2. a Claim by a Creditor Committee, Bondholder Committee, Equity Committee, Noteholder Committee, or similar committee established for the Insured Organization (or any assignee thereof), or
3. a Claim by the Insured Organization as Debtor-in-Possession (or any assignee thereof), provided that such Claim is made without the solicitation, assistance, or active participation of any Director and/or Officer.

Like any good lawyer, I can suggest alternative wording, but I have little conceptual quarrel with (1) and (2). It is (3), however, that troubles me from both an insured and insurer perspective, particularly when coupled with the column’s suggestion that the policy definition of insured organization should not include the company as a debtor-in-possession.**

When a company operates as a debtor-in-possession (“DIP”) under the Bankruptcy Code it continues to manage its own affairs without the supervision of any outsider such as a trustee. That is not to say, however, that it is not under considerable supervision from the bankruptcy court itself. For purposes of D&O insurance coverage by virtue of the Company definition, the DIP is the Company. Nonetheless, there is a wealth of bankruptcy jurisprudence as to whether the DIP is legally the same as the pre-petition entity.

Brokers typically insist on including it in the Insured Organization definition so that the DIP continues to enjoy any entity coverage that the policy may provide and that entering into DIP status does not trigger any “change in control” condition in the policy. On the other hand, precisely because the DIP is in a real sense the same as the company, insurers will not want to carve it back from the insured vs. insured exclusion lest they run the risk of de facto converting a liability policy to first party coverage or potentially exposing themselves to collusive claims. Indeed, the court decision that triggered the concerns expressed in the D&O MAPS column, Biltmore Assoc., LLC v. Twin City Fire Ins. Co., 572 F. 663 (9th Cir. 2009), recognized the legitimate interests of the insurer in avoiding these situations. Biltmore held that an assignee of the DIP stands in the shoes of the DIP, and its claims are thus barred by the I v I exclusion because the DIP is in turn the same entity as the original company that became a DIP. This was a well-reasoned decision of a respected federal appeals court and, with my admitted bias, I have no quarrel with it.

Thus, I would be reluctant to recommend to a client, whether insured or insurer, that they amend the definition and exclusion in the way that my friends at D&O MAPS suggest. Of course, insureds should welcome the carve-back in (3) above, so long as it is not coupled with a removal of the DIP from the definition of Insured Organization. Insurers, however, should strongly resist this for all of the reasons discussed above.

I welcome creative ideas and suggestions from the readership for a potential resolution.

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*I highly recommend that readers visit the IRMI website at www.irmi.com to learn more about the organization and what it offers.

**I suggest that the “provided that” clause at the end of (3) is not necessary if the exclusion itself is of the entity vs. insured variety and does not apply to claims brought by or on behalf of any insured person.

Almost every D&O commentator and source of information on emerging trends has noted that over the past twelve (12) months there has been a remarkable growth in securities fraud litigation against U.S. companies that are subsidiaries or affiliates of companies incorporated in the People’s Republic of China (“PRC”).

Much of the current wave of litigation in the U.S. against PRC companies arises from initial public offerings (“IPO”) as a result of a so-called “reverse merger” wherein a privately-held operating company in the PRC is acquired by a public shell entity in the U.S., which is also under control of the owners of the PRC operating entity. The owners and executives of the private entity assume voting and operational control over the combined entity resulting from the reverse merger. This transaction enables the private entity in the PRC to skirt the registration requirements of the Securities Exchange Commission (“SEC”), which apply only to the public shell in the U.S. While PRC companies are not the primary users of the reverse merger mechanism, they do constitute about 25% of such transactions over the past three years. Plaintiffs in the U.S. litigation typically allege inadequate disclosure because the only publicly-audited company is the PRC shell and the U.S. auditors rely heavily on auditors of the operating company in the PRC or other sources without any independent analysis. As a result, the private operating component allegedly escapes any heightened scrutiny from U.S. auditors. Since these suits only began to emerge in significant numbers about a year ago, few, if any, have been disposed by settlement or dismissed by motion.

One recent case that has drawn both a securities fraud class action and a derivative suit in the U.S. is that involving Puda Coal, Inc. In addition to the fraud allegations in the class action, the derivative suit alleges blatant breaches of fiduciary duty by the Puda board and in particular its chairman, Ming Zhao, in that Mr. Zhao was permitted to sell off the operating unit in the PRC to a private equity firm without the knowledge of the U.S. shareholders. Without the operating entity, which was a coal processor, the U.S. shell was relatively worthless.

Before turning to the insurance coverage issues, it is important to note that, although PRC companies have been in the forefront of this wave of securities litigation arising from reverse merger transaction, this by no means suggests that all such companies doing business in the U.S. are part of a fraudulent scheme. Indeed, at this early stage of the litigation process, it remains to be developed in many of these cases whether what may appear on its surface to be an intentional and knowing fraud and scam on the investing public, may in fact be the somewhat less culpable genre of reckless behavior due to unfamiliarity with corporate governance structures and desirable transparency in the U.S. Also, one need look no further than the debacles of recent years in Enron, Worldcom and countless others to appreciate that we have our share of Ponzi schemers and other home-grown fraudsters.

Although insurance coverage issues will vary from claim to claim, just as they do in other securities class actions and derivative suits, there may be issues in these cases peculiar to the fact that in these actions you might have claims asserted against the directors and officers of both the U.S. and PRC companies. There could also be overlapping boards with individuals holding insured positions in both companies. Complicating things even further may be the fact that the operations in the PRC may be insured under a policy issued there, while the U.S. company is insured by policies issued in the domestic U.S. market. The coverages may overlap and wordings may clash, giving rise to ambiguities and ultimately disputes.

As stated above, this genre of claims is still in an embryonic stage. Time will tell how liability, causation and damages, as well as coverage, issues emerge and are resolved.

This is the first guest blogger post on The D&OandE&OMonitor site and we are pleased to give that honor to my north of the border friend, Wency Keast. Wency is a Vice President at Directors Global in Toronto and most knowledgeable in international D&O issues and, in particular, those in Canada. The article first appeared in in the “Eyes on Governance”, an EMagazine for the members of the Institute of Corporate Directors ( Canada ), in the May 2011 issue. Wency’s observations are remarkably applicable not only to directors’ liability in Canada, but also under U.S. law and regulation as well. Wency can be reached at wency.keast@directorsglobal.com or 416.241.6100 x 203.

Although most directors are aware that their liability with respect to the execution of duties on behalf of the corporation is a personal risk, the impact of this personal liability is often placed on the back burner as day to day activities take precedence. Today, I request you join me for a few minutes to examine the personal risks and some consideration of the remedies that are available to you in the execution of your duties as directors of corporations. In the mitigation of some of the personal risk, you can draw comfort from the protections afforded to you through the governing acts of the jurisdiction where the company is incorporated, the bylaws of the corporations, and the insurance purchased by the corporations on whose boards you serve.

Governing acts generally permit corporations to indemnify and advance defence costs to directors for certain types of loss. Corporations are required to indemnify their directors, only as provided in the bylaws or certificate of incorporation. Hence the By-Laws of the Corporation that you serve on must contain language that allows the corporation to advance defence costs to you in the broadest terms that are possible in law. In derivative actions, the corporation may make an application to the courts to grant you indemnification or advancement of funds to defend yourself in suits brought against you by the corporation or any other entity to procure a judgement in favour of the corporation. The Act makes a provision for your right to indemnity from the corporation, provided you have been exonerated by a “court or other competent authority” (Ref: CBCA Subsection 124). You would have expended your personal assets in your defence before seeking such reimbursement.

In all circumstances, such indemnification or advancement of costs cannot be made to you unless you “(a) acted honestly and in good faith and with a view to the best interests of the corporation, or, as the case may be, to the best interests of the other entity for which [you] acted as director or officer or in a similar capacity at the corporation’s request and (b) in the case of criminal or administrative action or proceeding that is enforced by a monetary penalty, [you] had reasonable grounds for believing that [your] conduct was lawful” Ref: CBCA, Subsection 124, Limitation.

These provisions should allow for a certain amount of your peace of mind.  To disturb this tranquility, what if your corporation was not forthcoming in advancement of costs in your defence or in indemnification of costs already incurred? What if your corporation was insolvent?  If the corporation purchased insurance to transfer the risk do you know how to access this insurance? Do you have obligations to engage the insurer in your defence in order to be able to collect insurance? Do you know and understand the language of the Insurance Contract purchased by your corporation? Under what circumstances will the Insurer exclude coverage for suits brought against you? What factors make the policy null and void? Under what circumstances can the Insurance Contract be rescinded in its entirety, or against specific directors? Is the limit available for your defence shared by others, e.g. other directors, officers, the corporation itself, and other management?  Are the risks insured by the contract widened to include other liabilities, e.g. Employment Practices Liability for the corporation and its management? What is an adequate limit of insurance for your personal comfort zone and does your corporation carry this insurance solely for your benefit? These are areas that you must investigate. In most corporations, the purchase of insurance resides with the CFO or the Risk Manager, both good areas for the delegation of corporate risk – but yours is a personal risk.

The purchase of  Directors’ and Officers’ Liability Insurance is often corporate-centric, with corporations requiring coverage for the reimbursement of indemnification provided to directors and officers and for coverage for suits brought against the corporation itself by shareholders and others. These liability policies are not uniform in content and scope. Some features to look for are Dedicated Limits for Directors and Officers, Dedicated Limits for Independent Directors, a Priority of Payments Endorsement in favour of the Directors and Officers, and the broadest possible amendment or, preferably, the total removal of the Insured vs. Insured exclusion.  The Insured vs. Insured exclusion would not cover you should the corporation take action against you, or other directors and officers initiate action against you.  Policies are available for the sole protection of the Directors and Officers of a corporation – Side A.  This is an important consideration.  Today most Directors’ and Officers’ policies will cover the director following the bankruptcy of the corporation for certain statutory liabilities which are unique to directors. Even though insurance has been purchased, issues that remain include: Are the limits of liability unimpaired or adequate at the time when you need coverage? Is the policy still in place, e.g. was it cancelled for non-payment of premium?  Was coverage bound with an unfulfilled subjectivity?

A few Insurers offer a Personal Director’s Liability policy; however, at this point in time, these are follow form on underlying policies and serve primarily as an Excess Policy, or as a Difference in Conditions policy in the event of the insolvency of the corporation, there could be features in the programme that allow the director access to a defence where the insurer would be subrogated to the rights of recovery of such costs from the corporation.

The corporation is a separate legal entity and individuals who serve the corporation are insulated from personal liability for wrongful acts committed by the corporation   however, Federal and Provincial laws pierce the corporate veil and impose substantial personal liability on directors - it is estimated that there are approximately 100 such laws that apply in Ontario alone! Of significance are laws pertaining to employment, taxation, and the environment.

Where a corporation is unable to meet certain obligations, Statutory Law makes directors personally responsible for unpaid wages, vacation pay, corporate pension plan contributions, unremitted health insurance premiums and health taxes, source deductions e.g. Canada Pension Plan and Employment Insurance, obligations imposed under the Occupational Health and Safety Act, corporate obligations imposed on the individual Directors under the Income Tax Act, Sales Tax, Fuel Tax Act, Gasoline Tax Act, Federal Customs Act, the Canadian Environmental Protection Act.

Legislation allows for “joint, several, and solidary” liability against Directors with respect to many corporate obligations that are imposed on the Directors by statute. You could be the individual charged with the shortfall of unpaid wages etc.  You would be out of pocket for all of the upfront defence costs and judgements. In this situation, you would have the right to receive proportionate payment in reimbursement from other directors on the board, should a director be unable to meet the mandate, you would have met his/her proportionate payment as well as your own. 

Fiduciary responsibility imposed on directors is onerous because the stakeholders have granted and directors have accepted discretionary and unilateral power over the corporate holdings. Stakeholders are vulnerable to the effect of the exercise of this discretionary and unilateral power. They rely on their directors to exercise this power with prudence and diligence in the design and implementation of the governance of the corporation, the selection of competent officers to whom they delegate certain powers and duties, and in their continued oversight of the governance of the corporation’s affairs. To fulfil the mandate directors must, at all times be mindful of their duties of loyalty, of care, and be active in the design, oversight and enforcement of good governance on behalf of the corporation.

In summary, directors incur more personal liability than they think they do! This personal liability continues to be extended by legislation. It is important to make time for ensuring your personal protection, for continuing your education in respect to changing corporate legislation, and keeping up-to-date on what constitutes good governance. Your obligation to protect your personal assets, your family’s wellbeing, and the corporation’s assets and its competitive edge is a fine balancing act – don’t underestimate the importance of maintaining the balance.

Directors’ action: 

• Take personal responsibility for the protection of your assets, not only those that belong to the corporation(s) you serve.
• Examine the Corporate By-Laws, make amendments if necessary, to ensure that you receive the broadest possible protection from the corporation.
• Ensure that you are familiar with the governing legislation and keep up with legislative changes that affect you.
• The purchase of insurance in this regard is the protection of your personal liability and assets, get involved in ensuring that the programme is the best available for you.
• Always act with the key principles of loyalty, diligence, and care in the performance of your duties to the corporations you serve.

In a recent Missouri appellate decision, the Court invalidated a mandatory arbitration provision in a professional liability insurance policy leaving the parties to resolve their coverage differences by other means despite the clear wording of the policy. Sturgeon v. Allied Professionals Ins. Co., Case No. ED 94605, Missouri Court of Appeals (Decided March 8, 2010).

The underlying dispute was one of coverage under a professional liability policy issued to a Missouri licensed massage therapy practice. The underlying claim was brought in Missouri, which was the location of the insured risk, and the insurer was a risk retention group domiciled in Arizona and conducting business in California. The arbitration provision was mandatory as to all disputes arising under the policy and provided for an arbitration to be venued in Orange County, California.

The Court invalidated the provision based upon Missouri law and public policy that prohibits mandatory arbitration provisions in insurance policies. The insurer argued unsuccessfully that the Missouri law should not apply because (i) the Court found that Missouri had the greater interest for purposes of a conflicts of law analysis and declined to enforce the policy’s California choice of law provision, (ii) Federal Arbitration Act (FAA) preemption of Missouri law in this area was barred by the McCarran-Ferguson Act which otherwise exempted insurers from federal antitrust law, and (iii) the fact that the insurer was actually a risk retention group did not result in the federal Liability Risk Retention Act (LRRA) operating to provide it with protection that an insurer would not enjoy.

Arbitration is not necessarily a panacea for insurers to efficiently resolve coverage disputes in a favorable forum. While Sturgeon is illustrative of reasons why in at least one jurisdiction a mandatory arbitration provision may not be enforced, there are several other issues and factors that an insurer should consider even where arbitration may be somewhat voluntary.

• Arbitration may be as costly, as perhaps even more costly, than litigation for several reasons.

1.  
   1. There can often be formal document and deposition discovery in arbitration with preliminary and final hearings similar to court conferences and a trial on the merits.
   2. Arbitrators are typically compensated on an hourly basis at rates typically in excess of what an insurer’s own lawyers are being paid. Generally, the insurer will pay for its own party-appointed arbitrator plus half the fees of the neutral in the quite common three-member arbitration panel.
   3. Court costs are typically minimal, but administrative costs of the American Arbitrative Association (AAA) or similar administrator can be significant.

• Arbitration might, but not always, be a quicker process than litigation before a court with a crowded docket, including criminal matters that must take precedence because of constitutional rights to a speedy trial.
• Except in rare circumstances, there is no appeal from an arbitral award.
• While not an issue in Sturgeon, many courts may look unfavorably, based upon equitable considerations, upon enforcing an arbitration provision that forces a local business to arbitrate in another state. Here the Missouri insureds, apparently a small business and its employed masseuse, would have had to retain counsel and arbitrate over a thousand miles away in California.

Perhaps for many of the above reasons, as well as marketability, the landscape is currently somewhat varied as between insurers that have arbitration clauses in their professional liability policies and those that do not.

All three of these subjects sometimes scare those who know little about them, at times rightfully so and at others without just cause. Recently, developments with respect to each have raised some common issues.

First, let us turn to the Far East.

On February 25, 2011, the People’s Republic of China (“China”) enacted a law providing criminal sanction for the payment of bribes to government officials outside* China and to officials of international public organizations. The law is slated to take effect on May 1, 2011. The new law appears to provide only for imprisonment and not for awards of any fines, penalties or other monetary amounts. Prison terms can range up to a maximum of ten (10) years dependent upon the amount of the bribes at issue.

Although much remains to be seen as to how this new law will be implemented and enforced, the law should definitely have an impact on companies doing business in China because it specifically applies to a joint venture between a Chinese and non-Chinese company formed pursuant to Chinese law. At least at this juncture, it may be that this new law may be as major a cause of concern to foreign companies as is the case with the FCPA in the U.S. or similar laws in the U.K. and Canada for companies with shares traded on their securities exchanges or even merely doing business there, as the case may be.

Second, earlier this month Chartis, a major D&O insurer, introduced a new insurance policy product called Investigation Edge™. Based upon a review of the policy language and some of the Chartis promotional literature, the policy is intended to provide coverage to a company, but not for any of its directors or officers,** for various investigations undertaken by securities law enforcement authorities. The coverage is limited essentially to the costs of defending against or responding to an investigation, and specifically does not include coverage for any fines, penalties or other amounts that may be awarded or have to be paid in a settlement.

With regard to FCPA and similar violations, however, the new policy form contains the following exclusion.

The Insurer shall not be liable to make any payment for Loss in connection with any Investigation . . . of any actual or alleged bribery or violation of the U.S. Foreign Corrupt Practices Act of 1977, U.K. Bribery Act 2010, Canadian Corruption of Foreign Public Officials Act or any similar state, local or foreign law, rule or regulation.

Chartis marketing material notes, however, that optional FCPA coverage with a sublimit of $5M can be purchased.

Most D&O policies contain coverage for FCPA fines and penalties and the costs of defending against the investigations by the Securities Exchange Commission (“SEC”) or Department of Justice (“DOJ”) with language similar to the following found in Chartis’ Executive Edge™ product. The language is usually contained in the Loss definition in the policy form or added thereto by way of endorsement, and is limited solely to directors or officers of the company, but not the company itself.

. . . civil penalties against any Insured Person pursuant to Section 2 (g) (2) (B) of the Foreign Corrupt Practices Act, 15 U.S.C. § 78dd-2(g) (2) (B).

Unfortunately, the $5M limit will prove woefully inadequate in a barnburner of a FCPA investigation such as that ongoing against Avon Products where the company has disclosed that its own costs have reached approximately $100M.***

Nonetheless, the Chartis product is innovative and begs a number of questions as to what may ultimately follow.

• Will other insurers introduce similar products and, perhaps more importantly, be willing to write layers of excess insurance over it?
• Will Chartis consider increasing the $5M FCPA sublimit?
• Will other insurers incorporate this new investigation coverage for the entity into their existing D&O forms? At what premium?
• What is left to potentially cover? FCPA civil penalties awarded against a company? Costs of remediation or future compliance that is presently not covered?****

If all or most of these questions are answered affirmatively by many insurers, there may be a number of unintended consequences. As a prime example, little, if any, of this is of real benefit to independent directors. Corporations and brokers will have to consider buying significant additional excess limits and/or separate independent director liability (IDL) coverage to protect against the potential dilution by expanding coverage.***** Also, from the perspective of excess insurers, their attachment points will be more readily within reach with expansive underlying coverage and they will need to more closely monitor developments and expenses paid in underlying litigation and investigations in order to protect their interests.

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*It should be noted that so-called domestic bribery, i.e. bribes paid to Chinese government officials were already actionable prior to the enactment of this new law.

**Coverage for investigations targeting such individuals is already provided under most D&O policy forms available in today’s market.

***It was also reported on March 12 that a British lawyer was ordered to pay an amount of nearly $150M under the FCPA for bribery activity on behalf of Halliburton to Nigerian government officials. While D&O policies have the coverage enhancements discussed in this post, such broadening of coverage has been largely absent in the area of lawyers professional liability insurance.

****Despite the express lack of coverage for these costs in many policies, these types of costs were recently reported to have been borne by D&O insurers as part of a settlement of derivative litigation against Pfizer.

*****On top of all of this is the release within the last few days of the Cornerstone Research data on 2010 settlements in securities class actions. While mean settlement values dropped slightly from $37.2M in 2009 to $36.3M in 2010, the median settlement value increased drastically by over 41% to $11.3M. Settlements now often rip through many layers of excess insurance when coupled with covered defense and investigative costs.

Although the current wave of bank failures began in earnest in 2008 and about 325 institutions have failed and been shuttered by the Federal Deposit Insurance Corporation (“FDIC”) to date, the proverbial nasty stuff has yet to hit the fan.

Thus far, the FDIC has sued the directors and officers of only two of the failed banks and those suits did not come until 2010.  Rest assured, however, by way of a very educated guess that, with regard to the other 323 institutions, their executives have already received well-crafted “threatened claim” letters, which in turn have been passed on to their respective D&O insurers as a notice of circumstances that may give rise to a claim.  Thus, the coverages should be locked in and await only the formal filing of suit.  It should be noted that, although the FDIC has been relatively quiescent, private investors have already filed thirteen (13) class action lawsuits in federal courts and there are likely many others filed in state courts.

The last banking crisis of this magnitude was the so-called “S&L crisis” from about 1986 through 1992 when over 700 institutions, mostly savings and loans, failed.  At that time, the principal regulator was the Federal Savings and Loan Insurance Corporation (“FSLIC”), which brought numerous claims against directors and officers and parallel coverage actions against their insurers.

The major coverage issues then involved the insured vs. insured exclusion, as the FSLIC was suing as a successor in interest to the failed institution, and a regulatory exclusion specifically precluding coverage for claims brought by the FSLIC and other federal or state banking regulators.  Years of coverage litigation ensued and, while insurers were generally unsuccessful in having the insured vs. insured exclusion upheld, they ultimately enjoyed widespread judicial success in enforcing the regulatory exclusion.

What happened in the interim between the end of the S&L crisis and the looming crisis now facing community banks and their D&O insurers?

Most importantly, the insurers became complacent and largely dropped the regulatory exclusion from their policies despite its judicial validation. 

Will the number of claims increase in 2011 and coming years?  Consider the following.

• Well over 800 institutions are currently identified as “problems” by the FDIC.  Historical data has shown that such institutions rarely improve in their financial condition.  In fact, over 80% ultimately fail.
• Is the FDIC battle-ready?  In 2010, the agency hired 1,500 new employees and had a 55% budget increase.  You be the judge.

In any case where effective notice of circumstances has already been given to incumbent insurers, it may be too late to do much to avoid or minimize the exposure.  In other instances where new insurers may be coming on risk, careful consideration must be given to reintroducing the regulatory exclusion and eliminating prior acts coverage for troubled banks.  Yes, this vitiates the core coverage when it is most needed, but the alternative is to leave these banks and their directors and officers completely without coverage. 

It is not a pretty picture for community bank directors and officers, particularly those that now serve on failed or “problem list” institutions.

Although not frequent occurrences, D&O policies have always afforded coverage for so-called whistleblower claims.  Historically, the first claims in this genre were the qui tam claims filed under the federal False Claims Act.  They typically involved a company receiving government payments, e.g., a healthcare provider receiving Medicare payments as a result of fraudulent billing practices.  The whistleblower there was typically an employee of the provider organization and the reward or “bounty” was a sharing in whatever the government collected through a prosecution of the provider.  The D&O policy afforded coverage to the extent one or more officers and directors of the provider company were defendants in the action, although coverage could be somewhat limited to the extent certain conduct exclusions might ultimately apply to any settlement or judgment amount.

Next, and within the past ten years, came specific policy language providing coverage for whistleblower claims under Sarbanes-Oxley.

The latest, and perhaps most significant development in terms of potential frequency and exposure, may be the new SEC whistleblower initiatives proposed as Regulation 21F to Section 21 F of the Securities Exchange Act of 1934 as a result of the enactment of the commonly-called Dodd-Frank Act earlier this year.  Whistleblowers would get an award so long as the SEC could be successful in collecting monetary sanctions exceeding $1,000,000. 

The whistleblower must provide original information that leads the SEC to a successful enforcement, i.e. the information causes the SEC to commence an investigation or provides information about a matter already under investigation.    The whistleblower’s award can range from 10 to 20 percent of the monetary sanctions collected.  The SEC would appear to be the sole arbiter of the amount of the award.  The proposed rule is still open to public comment, and it is likely that enactment will not occur until sometime in 2011.

Although this new regulation may lead to additional claim activity and hence defense costs exposure under D&O policies, it is not likely that either the total sanctions or the whistleblower’s cut of them would amount to covered loss under the policy.  But, because these whistleblower claims are apt to be occurring somewhat contemporaneously with shareholder class actions and derivative litigation, they may well provide an undesired enhancement to the settlement value of those otherwise covered actions.