The subprime mortgage crisis implicates billions of dollars in directors and officers insurance coverage. Naturally, insurance companies will, in many instances, argue that directors and officers insurance coverage does not exist under several exclusions typically contained in a directors and officers (D&O) policy. What should not be lost in the brewing debate is that this war was fought before — during the battles for directors and officers coverage arising from the savings and loan (S&L) crisis — and many of the issues raised then are likely to be raised again.
Strictly from an insurance coverage perspective, there are many similarities between the current subprime mortgage crisis and the S&L crisis of the 1980s. And although the dynamics of the subprime liability litigation are evolving, much of the same policy language and many of the same exclusions will likely play an important role. There are, however, some notable differences.
The Song Remains the Same, Although the Policy Language May Have Changed
Claims for directors and officers coverage arising from the collapse of the subprime market are coming — there is no question about it. On May 13, 2008, the United States District Court for the Central District of California, in In Re Countrywide Financial Corp. Derivative Litigation, refused to dismiss claims against Countrywide's directors and officers brought by several pension funds. The pension funds had alleged that Countrywide's directors and officers did not properly monitor Countrywide's practices, "missed red flags," and caused Countrywide to issue various false and misleading statements to the public.1
Taking a different tack, but still pointing up potential problems for directors and officers, on April 18, 2008, UBS published a shareholder report that concluded that its losses in the subprime market were caused, in part, by the absence of risk management, lack of operational or notional limits, and incomplete risk control methodologies.2
The myriad of suits filed against lenders — and often their directors, officers, or key executives — winding through the courts typically allege imprudent investment of assets, negligence, misrepresentation, conspiracy, and federal securities law violations under the Securities Exchange Act of 1934 and the , among other things — in short, a gamut of potential liability. What should not be missed is that the same allegations were made years ago against the directors and officers of failed savings and loan institutions. Just as those directors and officers sought insurance coverage under their D&O policies, directors and officers implicated or affected by the subprime crisis will certainly seek to access their own D&O coverage.3
Differences and Similarities in the Policy Language
The policy language in directors and officers policies varies more than in other types of insurance forms and has changed in certain respects since the savings and loan crisis. For instance, many older D&O policies excluded specific types of securities violations that may be implicated in seeking insurance coverage for a claim arising from potential subprime liability. But newer directors and officers policies typically remove these exclusions from coverage because protection from allegations of securities violations is precisely the type of "wrongful act" for which insurance coverage is sought for a corporation's directors and officers. Many modern directors and officers policies specifically provide coverage for a securities claim arising under the 1933 or 1934 Act or state securities laws.
The Battles Likely to Be Re-Fought
Several insurance industry exclusions that began to appear in response to the savings and loan crisis continue to raise potential issues.
Regulatory Exclusion
The first, less likely to be a problem, is the "regulatory exclusion," which typically excludes losses for claims based upon actions brought by a regulatory agency.4This exclusion is typically narrowly construed5 and has been disappearing from D&O policies in recent years. In any event, most subprime losses are in the civil context and are not brought by a regulatory agency. In addition, many modern directors and officers policies cover "investigations by any governmental entity into violation of law" in the policy's definition of "claim" and cover defense costs incurred in responding to a government or regulatory examination.
Insured v. Insured Exclusion
More likely to be an issue in subprime claims is the "insured v. insured exclusion," which typically excludes indemnification for claims against directors and officers alleged by other directors and officers or policyholders under the same policy. During the S&L crisis, insurance companies often relied upon this exclusion in attempts to bar D&O claims. Like the regulatory exclusion, prior to the mid-1980s, the insured v. insured exclusion was rarely seen in D&O policies.6
No Standard Insured v. Insured Exclusion
Through the years, there has not been a standardform insured v. insured exclusion, and interpretation of the exclusion is fact-specific and turns on the exact wording of the given exclusion. The most sweeping wording excludes coverage for any claim "brought by any Insured or by the Company, or which is brought by any security holder of the Company, whether directly or derivatively, unless such security holder's Claim is instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of, any Insured or the Company ...." But some insured v. insured exclusions except shareholder derivative actions, wrongful termination claims, and/or claims for contribution and indemnity brought by an insured against another insured.
When such coverage defenses were litigated, decisions construing the insured v. insured exclusion consistently held that the purpose of the exclusion is to prevent collusion between the named insureds.7 In the subprime context, avoidance of collusion would not be an issue, as many subprime liability lawsuits are brought as derivative lawsuits (the issue would likely be the application of a particular insured v. insured exclusion). Courts construing the insured v. insured exclusion in the savings and loan context often found the exclusion inapplicable, but the decisions are far from uniform given the importance of the wording of the exclusion at issue.
Potential Ambiguities in Applying the Insured v. Insured Exclusion
In determining insurance coverage for directors and officers of failed savings and loan institutions, the courts split on the question of whether the insured v. insured exclusion was ambiguous as applied to a regulatory agency, with the dispositive question being whether the court considered a regulatory agency to stand in the shoes of the failed lending institution, and, as such, to be an "insured" under a given exclusion.8
When a stockholder brings a derivative claim — including complaints alleging mismanagement in connection with subprime lending — the board of directors forms a special litigation committee (SLC) comprised of independent directors uninvolved in the allegations of wrongdoing. The SLC is charged with discovering the veracity of the allegations within the derivative lawsuit. Unless expressly excluded, the costs of an SLC investigation should be covered by the D&O insurance. But as in the savings and loan context, depending upon the wording of the policy, the insured v. insured exclusion may be ambiguous with respect to whether it will apply to an SLC.
Bad Acts Exclusion
The "bad acts" exclusion is, and was, among the most prominent exclusions in a directors and officers policy and typically excludes coverage for liabilitybased allegations of fraud, criminal acts, or intentional misconduct. Now, as during the savings and loan crisis, however, the law is clear that the insurance company cannot rely upon the "bad acts" exclusion until the underlying claim is adjudicated in a court of law.9 Until a final determination is reached, the policyholder under a directors and officers policy will be entitled to the advancement of legal costs incurred in defending against the claim.10
A typical directors and officers policy will provide coverage for claims arising from "wrongful acts," which usually includes "any breach of duty, neglect, error, misstatement, misleading statement, omission or act by directors or officers in their capacity as such." A common insurance company argument during the savings and loan crisis (and in many other coverage disputes) is that notwithstanding this broad grant of coverage, indemnification is available only for negligent acts and not for intentional acts. The law is clear, however, that an intentional act with unintentional consequences — an act intentionally done, but which was not intended to violate the law or to cause harm — should be covered.
Rescission Due to Misrepresentations
During the savings and loan crisis, insurance companies sought to rescind insurance coverage based upon "misrepresentations" made by management in the application for insurance. They will doubtless try the same tack when faced with subprime claims. Any ongoing investigation of the underlying case could produce a finding that the policyholder made misstatements in its public filings, for instance, overestimating the value of its subprime assets. Many subprime lawsuits allege that the lender's directors and officers were aware of the risky nature of the loans but failed to take appropriate steps. Similarly, many subprime suits allege that the company's financial statement — which generally must be submitted as part of a directors and officers insurance application — contained misrepresentations or was inaccurate. A court's upholding of such an allegation could ultimately be grounds for rescission.
Most attempts at rescission fail, however. The key to rescinding a policy and denying coverage based upon an alleged misrepresentation is that the insurance company: (i) bears the burden of proof, (ii) must show that the misrepresentation was material to its decision to sell the policy, and (iii) must show that the misrepresentation was in fact made by the policyholder.11 In addition, many directors and officers policies now limit the ability of the insurance company to rescind coverage for individual insureds. Some policies provide coverage for insureds unaware of inaccuracies in disclosures in financial statements or to the SEC, while some protect all individual insureds.
"...Someone's Going to Get Sued"
As one unnamed underwriter for a leading insurance company stated, there is "D&O and E&O (errors and omissions) exposure all over the place. Wherever someone had their fingers in the pie, someone's going to get sued."12 That appears more than likely.
James Fournier, Of Counsel in the Washington, D.C., office of Anderson, Kill & Olick, P.C., regularly counsels clients on a variety of insurance recovery and commercial litigation issues. Over the past decade, he has assisted policyholders in obtain-ing insurance coverage for liabilities stemming from defective construction products, construction defects, lead paint, asbestos, pollution, and a variety of other first- and third-party liabilities taking place throughout the United States and its territories. Fournier has also litigated matters involving determinations of insurance company bad faith and defense obligations.
Diana Shafter Gliedman is the coordinator at Anderson Kill and Olick for this column. Gliedman is an attorney practicing in Anderson Kill's New York office and regularly represents policyholders in insurance recovery litigation and mediation.
Footnotes
1.In Re Countrywide Financial Corp. Derivative Litigation, No. CV-07-06923 (C.D. Cal. May 13, 2008).
2. UBS, "UBS Issues Shareholder Report on Write-downs," Press Release (April 18, 2008). Available athttp://www. ubs.com/1/e/investors/releases.html?newsId=140339.
3. Although this article focuses on insurance coverage under directors and officers policies, coverage for subprime market-related liability may exist under errors and omissions, comprehensive general liability, financial institution bond, mortgage bankers professional liability, or fiduciary liability policies.
4. Peraino, Vito, "The Impact of the Savings & Loan Crisis on the Insurance Industry," Directors' and Officers' Liability Insurance (New York: Practicing Law Institute, 1991): 431 (noting that D&O insurance policies began to include a regulatory exclusion in response to regulatory agencies' attempts to hold directors and officers responsible for savings and loan losses).
5. See American Cas. Co. v. FSLIC, 704 F. Supp. 898, 904 (E.D. Ark. 1989).
6. Chimicles, Nicholas E., and M. Katherine Meermans, "The Insured v. Insured Exclusion in D&O Insurance Policies," C938 American Law Institute – American Bar Association (June 17, 1994): 751.
7. Trustees of Princeton University v. National Union Fire Ins. Co. of Pittsburgh, Pa., 15 Misc.3d 1118(A) (N.Y. Sup. 2007), 839 N.Y.S.2d 437 (Table).
8. Peraino, ibid., 441–44 (collecting cases).
9. See, e.g., In re Donald Sheldon & Co., Inc., 186 B.R. 364, 369-70 (S.D.N.Y. 1995).
10. See, e.g., Federal Ins. Co. v. Koslowski, 792 N.Y.S.2d 397, 404 (App. Div. 2005).
11. Home Insurance Co. of Ill. (New Hampshire) v. Spectrum Info. Tech., 930 F. Supp 825, 843 (E.D.N.Y. 1996). 12. "U.S. Legal Battles over Mortgage Crisis Could Cost London Insurers," Financial Times (August 20, 2007).
Reprinted with permission from The John Liner Review,
Volume 22, Number 2; Summer 2008.
Copyright 2008, Standard Publishing Corp., Boston, MA.
All rights reserved.
www.spcpub.com
The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations
