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.