Two recent court decisions emphasise the importance of contract certainty when providing D&O coverage, explain Richard Bortnick and Emilio Boehringer
As the severity of directors' and officers' (D&O) claims increases exponentially, the frequency of insurance coverage disputes under D&O policies is similarly rising - whether in the context of a claim for rescission, a dispute over the scope or extent of a policy exclusion, or simply the meaning of a policy term or condition. Indeed, D&O insurers and their policyholders now spend (some would say "waste") millions of pounds and dollars per year on legal costs related to D&O coverage.
In fact, the UK's Financial Services Authority is determined to put an end to what it refers to as the "deal now, detail later" industry culture which often engenders coverage questions. Surely, commonsense dictates the need for certainty? It should not take a regulator to tell us that.
Nonetheless, scores of coverage disputes proceed annually to litigation and/or arbitration to resolve what some might say are simple issues that could (and should) have been avoided had the parties mutually understood the meaning, scope and extent of the insurance provided. In that circumstance, the ultimate coverage determination falls into the hands of a neutral third party who was neither present during contract negotiations nor involved with the policy construction.
Needless to say, these fact finders strive to get it right. In so doing, they typically interpret and enforce the language of the insurance policy before them. What would seemingly appear to be a straightforward coverage analysis, however, might not be so clear-cut when left to resourceful policyholder counsel and/or creative adjudicators willing to liberally construe a policyholder's arguments. The absence of a policy and/or policy formation documentation makes it far too easy for them to operate.
When a loss isn't a loss
All D&O liability insurance policies include, among their provisions, a definition of the term "loss" which must be satisfied in order for coverage to attach. A number of US courts have held that "loss" under a D&O policy does not include legal remedies such as restitution, disgorgement, stock transfers, and the return of ill-gotten gains. In those cases, US courts declined to extend the defined term "loss" beyond its plain and unambiguous meaning.
The court's decision in Enterasys v Gulf Insurance is instructive. In Enterasys, a US federal judge ruled that an insured entity's issuance of $33m in stock to settle a class action lawsuit did not constitute "loss" and, therefore, was not covered under excess D&O policies. In Enterasys, the defendant/policyholder sought indemnity with respect to a securities fraud class action lawsuit which it settled by paying the claimants with common stock consisting of newly issued shares and treasury stock. Enterasys' D&O insurers declined to indemnify it for the stock payments and requested a judicial determination that Enterasys had not suffered "loss," which was defined in the relevant policies as "damages, judgments, settlements, costs, charges and expenses ... incurred by any of the (insureds)."
In support of its indemnity claim, Enterasys argued that the court should not distinguish between the corporation and its shareholders, positing that if its shareholders suffer economic detriment resulting from the corporation's issuance of stock, then the corporation similarly suffers a loss.
In finding for the insurers, the court dismissed Enterasys' argument, observing that the entity's shareholders were not named insureds under the relevant D&O policies and that the entity was distinct and separate from its shareholders. The court also found that Enterasys did not suffer any harm from a reduction in its assets by virtue of the settlement; and furthermore perceived a potential for abuse inherent in a contrary decision, recognising that corporations could easily originate stock to settle claims and thereafter seek reimbursement for the value of the shares, resulting in a windfall.
Two sides to Side A
D&O policies contain various types of insuring agreements. Virtually all D&O policies include "Side A" coverage, which is designed to indemnify individual directors and officers but does not insure a corporate entity. Accordingly, where a policyholder purchases only Side A coverage, it would be logical for the parties to believe that the entity is not covered for future lawsuits against it.
As reasonable as this proposition may seem, it may be wrong in certain circumstances. Indeed, in Rightime Econometrics, et al v Federal Insurance Company a US federal court found two corporations which purchased only Side A coverage potentially could be insured for a lawsuit in which they, but none of their directors and officers, were named as parties.
Rightime evolved from an underlying class action lawsuit in which investors sued two corporate entities for securities fraud. Although the lawsuit did not name the entities' directors or officers as defendants, the entities sought coverage and alleged bad faith under a Side A insuring clause which provided indemnity for "loss on account of any D&O Claim first made against an insured person during the policy period ...". The term "insured person" was defined as "all past, present or future duly elected directors, duly elected or appointed officers, partners, trustees or members of the insured organisation ...". Faced with this claim, the D&O insurer denied coverage. The entities responded with a lawsuit seeking a declaration that the insurer was obligated to indemnify them and accusing the insurer of bad faith. The insurer moved to dismiss, arguing that the plain language of its Side A insuring agreement precluded coverage for lawsuits against corporate entities. The entities countered that they possessed a "reasonable expectation" of coverage because the insurer consistently had represented that the insuring agreement would provide "entity coverage", irrespective of whether there was a claim against a director or officer.
Initially, it appeared that the court would ratify the insurer's seemingly reasonable position, as it correctly recognised that "the language of the D&O (insuring) clause unambiguously excludes from coverage the types of claims asserted" in the underlying lawsuit. Nevertheless, the court rejected the insurer's view, ruling that the relevant policy's unambiguous language would have to be disregarded if the entities could prove that the insurer's conduct created a "reasonable expectation" of coverage. Nonetheless, the court acknowledged that "it is not easy to suppose that (the entities) could have reasonably expected coverage ... in the absence of a claim against" an officer or director. Despite this apparent incongruity, the court interpreted the law to mandate discovery into whether the insurer had represented that the entities would receive coverage.
Equally troublesome, the court found that the entities' allegations were sufficient to give them the right to proceed with their bad faith claim. Accepting as true the entities' claim that the insurer knew it lacked a reasonable basis to deny coverage, the court observed that if the insurer had made the representations alleged, then its denial of coverage plausibly could be characterised as unreasonable and taken in bad faith. Conversely, if no such representations had been made, the claims would fail.
A lesson in contract certainty
Although seemingly unrelated, both Enterasys and Rightime Econometrics demonstrate the necessity of good record keeping, prudent underwriting, and precise policy terms and conditions.
With respect to policy formation, Rightime Econometrics instructs that all communications be documented. Enterasys illustrates that when an underwriter uses precise policy language, the insurer will not be required to pay for matters it did not intend to insure and/or for which no premium was received. Underwriters may want to incorporate the teachings of Enterasys into their D&O policies, specifically excluding from the definition of "loss" those settlements or portions of settlements comprised of stock. At the same time, underwriters should:
- Keep track of all oral communications regarding the insurance to be provided through detailed writings, including by way of precise policy terms, conditions, definitions and exclusions;
- Consider adding a merger clause to policies in order to avoid a policyholder's claimed reliance on oral representations outside of the contract. Such a provision might state that the policy represents the entire contract between the parties, and the parties, in forming their contract, did not rely upon any representations, express or otherwise, beyond those contained in their written agreement; and
- Issue and deliver insurance policies in a timely manner.
Through the use of such conditions, an insurer may be able to avoid litigation over the meaning, scope and extent of an insurance policy and protect itself from claims of bad faith. Needless to say, the current vintage D&O insurance forms are sufficiently broad. There is no reason for a D&O insurer to expose itself to even more enhanced coverages when such a result could have been avoided simply by memorialising the parties' representations, warranties and agreements in writing. Conversely, the costs (both defense and indemnity) ensuing from an insurer's failure to protect itself could be tremendous. Prudence dictates that insurers adopt preventive measures and protect both their shareholders' and their own capital.
- Richard Bortnick (firstname.lastname@example.org) and Emilio Boehringer (email@example.com) are attorneys at Cozen O'Connor.