Directors & Officers Insurance Coverage: Half Full Or Half Empty?

Thursday, March 1, 2007 - 00:00

When directors and officers are sued, they turn to their Directors' and Officers' ("D&O") insurance policies for protection. All too frequently, the insurance company denies coverage, and the policyholder must resort to the courts for relief. As the case law demonstrates, insurers have enjoyed their fair share of success recently, and outside directors in particular are concerned that the D&O policies upon which they rely will not be there when it counts.

To a significant degree, the insurance industry has responded to these concerns by writing better policies. Many D&O policies now have provisions severely limiting the insurance company's ability to rescind the policy. Separate, non-rescindable coverage for individual insureds to cover non-indemnified liability is available. New policy provisions also address the issues of priority of payments and access to the policy in bankruptcy.

However, heavily litigated issues remain. One hotly disputed issue is whether so-called "restitutionary" relief meets the policy definition of covered "loss" or "damages." The restitution issue arises when, for example, a court finds that a company has paid too little in exchange for shares of stock and orders the company to make an additional payment. Insurers theorize that in such a case, the insured is only paying what it should have paid in the first place, and thus covered damages are not involved. Early cases acknowledged this restitution defense chiefly when the insureds seeking coverage engaged in some wrongful conduct; courts often stated that coverage did not exist for the return of 'ill-gotten gains.' More recently, though, courts have looked more to the type of damages involved and less to the conduct of the insured, and have denied coverage even when the insured was without fault.

A second persistent issue is the effect of the "insured v. insured" exclusion. The insurance industry placed this exclusion in the D&O policy to protect itself against collusive suits. Historically, most courts have interpreted the exclusion strictly to apply by its terms to any suit by a past, present or future director or officer against another, and against the corporation itself if entity coverage exists. More recently, though, courts have looked past the exclusion's literal terms, and at its intent instead, to determine that coverage exists in suits between directors and officers if the suit is not collusive.

Pan Pacific v. Gulf: Looking Past Restitution?

In Pan Pacific Retail, et al. v. Gulf Ins. Co., et al. ,1 the Court of Appeals for the Ninth Circuit opened a door, however slightly, for recovery under D&O policies for claims brought by shareholders seeking restitution.

Pan Pacific arose from a merger of that company with Western Properties Trust ("Western"). Under the plan of merger, all shares of Western would be acquired by Pan Pacific in exchange for stock of Pan Pacific. A state court class action was filed challenging the merger, alleging various statutory claims for violation of disclosure laws, claims for making false or misleading statements in connection with the purchase of securities, and several derivative claims.

The court eventually dismissed the derivative claims, leaving only the four statutory claims, as well as a breach of fiduciary duty claim arising from a failure to disclose. The state court held that these claims could go forward "because each shareholder has an individual right to accurate information from the corporation," but did not "determine how a remedy or damages could be determined."2 Thereafter, the state case settled.

Following denial of coverage of the claims by their insurers, Pan Pacific and Western filed suit, "alleging that Gulf and Twin City unjustifiably refused to recognize insurance coverage."3 The United States District Court granted summary judgment to the insurance companies, finding that the settlement was "restitution" and thus uninsurable as a matter of law.4 In other words, the settlement was "uninsurable because the payment as a factual matter only reflected additional consideration that was wrongfully withheld in the merger."5

The Ninth Circuit Court of Appeals started with the proposition that claims for restitution are normally outside the scope of coverage - "one may not insure against the risk of being ordered to return money or property that has been wrongfully acquired."6 However, the Court noted that the label placed on the claim is not dispositive of whether the claim is within the scope of coverage. Rather, "in deciding whether a certain remedy is insurable, [the Court] must look beyond the labels of the asserted claim or remedies."7

Although the Court noted that the settlement might have been motivated by a fear that the dismissed derivative claims might be reinstated on appeal, the Court reasoned that such a position would render the settlement outside the scope of coverage as "such derivative claims would necessarily seek to divest money that was improperly obtained or withheld."8 Nor could the settlement be based on a theory that the wrongdoing of management decreased the value of the Western stock because such would necessarily mean that every stockholder was injured (akin to a derivative claim), and as a matter of law (at least in California) a shareholder is barred from bringing a direct claim against management on such a theory.

Instead, the Court relied on an "alternative theory" - "value of the information allegedly withheld" - as a potential ground for coverage and thus reversed the grant of summary judgment in favor of the carriers.9 This theory escaped the defects of derivative claims in that it "would provide compensation for the individualized harm of the shareholders and not for the return of money wrongfully withheld."10 The Court was not troubled by the fact that such a theory "might only result in a minimal economic recovery," nor by the fact that such a theory "might not account for the entire amount paid in settlement."11 Rather, the Court was convinced that the record contained material issues of fact as to the nature of the settlement and, thus, remanded for a determination whether the entire settlement was for uninsurable relief.

Similarly, the Court ruled that to the extent the trier of fact finds that "the settlement should not be characterized in full as reflecting uninsurable restitutionary relief and finds that the insurers must reimburse for any part of the settlement, then the defense costs reasonably related to these covered claims must also be reimbursed."12

In looking past the carrier's casting of the claim as one for restitution and finding a theory of recovery not based on a return of property, the Pan Pacific Court has opened the door for recovery on claims typically dismissed as unrecoverable. The D&O policyholder now has an argument that shareholder claims made in connection with the merger of companies and the sale/purchase of stock may indeed be covered. By casting such claims and the settlement thereof as something other than restitution, D&O coverage may exist.

MegAvail v. Illinois Union: Finding Coverage For Non-Collusive Suits

In MegAvail, Inc. v. Illinois Union Ins. Co. ,13 the federal district court found coverage for a suit brought in part by corporate officers, despite the standard D&O "insured v. insured" exclusion. The MegAvail court sided with those cases that looked to the intent of the exclusion - to prevent collusive suits - to find coverage for truly adversarial claims brought by corporate officers.

MegAvail involved the duty to defend a shareholder suit brought by plaintiffs who included former directors and officers of the company. Specifically, four minority shareholders and two former directors and officers claimed MegAvail "effectively squeezed them out of the corporation and forced them to relinquish their patent rights by illegally diluting their shares and imposing unjustified debt on the company."14 MegAvail had a D&O policy containing a typical "insured v. insured" exclusion. The exclusion provided that the carrier "is not liable to defend any claim filed 'by, on behalf of, or at the direction of any of the Insureds,' which includes 'all persons who were, now are, or shall be directors, officers or employees' of MegAvail."15 The exclusion also contained an exception providing "that such a claim will be covered 'to the extent such Claim is brought derivatively by a security holder of [MegAvail] who, when such Claim is first made, is acting independently of all of the Insureds.' "16

While the "insured v. insured" exclusion is standard in D&O policies, it is important to note that the language can differ among carriers. In particular, some D&O policies have important exceptions to the exclusion's application. The basic exclusion, as in MegAvail , is drafted to preclude coverage for "Claims" made against an "Insured Person" or the "Company" brought by or on behalf of an "Insured Person." Past, present, and future corporate officers and directors are defined as "Insured Persons."

MegAvail tendered the defense of the suit to its D&O insurer, Illinois Union Insurance Company ("IUIC"), which denied coverage because of the "insured v. insured" exclusion. Both parties moved for summary judgment. IUIC argued the exclusion unambiguously excludes coverage for any claims brought by any insured person. MegAvail contended that the policy, read as a whole together with the exclusion contemplates that suits brought by one or more "insured" plaintiffs does not exclude all claims, and that even if such claims were otherwise excluded, shareholder derivative claims fall within an exception to the exclusion. MegAvail prevailed. The court found that the officers' claims were non-collusive and thus denying coverage would be inconsistent with the intent of the exclusion.

A split has now occurred among courts. Some courts continue to interpret strictly the language of the exclusion and deny coverage based solely upon the plaintiff's status as an insured regardless of the nature of the claim.17 MegAvail advances the broader viewpoint of other courts who also consider the intent of the exclusion and look to whether the suit is potentially collusive.18

Courts adhering to a strict view of the exclusionary text abide by the general rule of construction that they may not create ambiguity in a contract where none exists in order to look beyond the text to discern its intent. For these courts, their analysis ends where it began - with a plaintiff who is or was an "insured" corporate officer. However, MegAvail and other courts rely on countervailing rules of interpretation: (1) that policy exclusions should be favorably interpreted for the benefit of insureds, (2) that policies must be read as a whole, giving meaning to all of their terms and (3) that an insurer's duty to defend is greater than its duty to indemnify. For courts like MegAvail , this analysis requires comparing the complaint's substantive allegations with all of the policy's applicable terms, in order to apply the intent of the exclusion.

The court in MegAvail also supported its decision on the basis of the D&O policy's "allocation" clause, found in many D&O policies. The clause required the insurer to allocate indemnity payments and defense costs between covered and uncovered losses. Since four of the six plaintiffs in MegAvail were not "insured" persons, coverage existed for their claims regardless of the "insured v. insured" exclusion.

Conclusion

D&O insurance law is constantly changing. As discussed above, courts differ dramatically in their interpretation of critical provisions. Also, unlike general liability policies, key terms are not standard, and may differ from policy to policy. D&O insurance policies also evolve to meet policyholder concerns and thereby be more competitive in the marketplace. A company must consider carefully the terms of its D&O policy to make certain that it has the best protection. Insureds must also constantly review the case law in order to present the best, most creative arguments in D&O coverage battles.

Robert D. Chesler is a Member of Lowenstein Sandler PC, Roseland, New Jersey, and Chair of the firm's Insurance Practice Group. David G. Tomeo is a Member of the firm and Chair of its Litigation Department ADR Practice Area. Stefan B. Kalina is Counsel in the firm's Litigation Department. For the citations and information to which the above footnotes refer, please see this article on our website, www.metrocorpcounsel.com.

Please email the authors at rchesler@lowenstein.com, dtomeo@lowenstein.com or skalina@lowenstein.com with questions about this article.