Securing Insurer Funded Resolution of Securities Lawsuits
/Securing Insurer Funded Resolution of Securities Lawsuits
By David A. Gauntlett*
Introduction
Whether government investigations by the Securities Exchange Commission (“SEC”), Department of Justice (“DOJ”), another federal or state entity, or unanticipated drops in Company stock value precipitate shareholder litigation, securing the best possible insurance coverage to address the asserted claims is critical. The entity then evaluates whether actionable conduct has arisen that allows a government agency to pursue a claim. Such investigations create significant potential exposure for policyholders in investigation costs. Additionally, in responding to government subpoenas or demands for information, even before the start of an investigation, policyholders often expend significant amounts of time and money securing the information required. Luckily, reimbursement may be attained through a policyholder’s “Directors and Officers (“D&O”), Errors & Omissions (“E&O”), or Commercial General Liability (“CGL”) policy.[1]
Obtaining reimbursement for any settlements resolving the matter is also possible. While some payments explicitly labeled as punitive may be uninsurable, any other payments, including those for “disgorgement,” can slip through the typical policy exclusions.
Potential for Coverage under E&O and CGL Policies
Although coverage for securities litigation is more commonly found in D&O policies, Allstate Ins. Co. v. Interbank Fin. Servs.[2] considered the potential for coverage under a CGL policy. The insured faced ten state court actions alleging that “the representations [that it was a tax shelter] were false, that the federal government had ‘challenged the tax treatment,’ and other investors had not ‘passed court review and/or audits of their tax deductions’ under the program.”[3] The court concluded that:
The policy covers losses resulting from accidental events which cause bodily injury or property damage, not the giving of professional or investment advice. . . . [A]lthough the insureds attempt to characterize the claims differently, the clear bases of the complaints are that the insureds gave poor professional advice and the plaintiffs lost money in a tax shelter investment.[4]
This type of claim, the court noted, would fall within the boundaries of an E&O policy, but not the CGL policy at issue.[5]
Under slightly different facts, however, a different result may have occurred. For example, consider a financial institution that falsely promotes its capabilities through an advertising campaign it copies from a competitor. In that instance, coverage may arise under a CGL policy’s offense (f), which covers “use of another’s advertising idea in your ‘advertisement.’”
Key Coverage Issues in Defending Security Class Action Litigation
Obtaining coverage for any eventual payments will depend on dodging exclusions both within the contract and imposed by applicable state laws. The contractual exclusions can vary from case to case, but policies typically preclude coverage where the insured has gained a profit or remuneration to which the insured was not entitled as well as any claim arising out of “any deliberately dishonest, malicious, or fraudulent act,” “or any willful violation of law by any Insured,” provided such conduct was “finally adjudicated” and “in fact occurred.”[6]
Securing a settlement without a direct admission of guilt is the best way to avoid implicating the policy’s exclusions. In a recent prominent ruling related to Larry Nassar, the physician who sexually assaulted numerous young women at Michigan State University and on the USA Gymnastics team, the Seventh Circuit emphasized the significance of the final adjudication requirement when considering USA Gymnastics’ attempt to obtain coverage for various lawsuits and investigations under its D&O policy.
In his plea agreement with state prosecutors, Nassar admitted guilt to ten counts of criminal sexual conduct, with the prosecutors agreeing not to pursue over 100 other cases against him.[7] The insurer refused coverage for subsequent civil claims, contending that Nassar’s actions triggered the policy’s “willful violation of law” exclusion, given that the criminal proceeding satisfied the “final adjudication” requirement.[8]
The court dismissed the insurer’s argument for all counts except the ten specific ones to which Nassar pleaded guilty, explaining that the final adjudication provision “is an important and often bargained-over feature of D&O policies” and should be “strictly construed.”[9] This same strict construction applies in SEC cases. One court has even gone so far as to hold that an SEC administrative order is not a final adjudication for the purposes of a contract exclusion because it is not “a judicial determination regarding the legality of the conduct.”[10]
Indemnification for Settlement Payments Resolving SEC Investigations
In J.P. Morgan Sec. Inc. v. Vigilant Ins. Co.,[11] the SEC investigated claims that the policyholder (Bear Stearns) had facilitated late trading and deceptive market timing practices by its customers in connection with the purchase and sale of shares of mutual funds. Bear Stearns settled with the SEC and agreed to pay a $160M “disgorgement” payment and a $90M “civil money penalty” payment.[12] The settlement order directed that the $90 million payment—but not the disgorgement payment—was ineligible to offset any sums owed by Bear Stearns to private litigants injured by the trading practices. Bear Stearns was also required to treat the $90 million payment as a penalty for tax purposes.
Bear Stearns sought reimbursement of $140M of the “disgorgement” payment, but the insurer denied coverage, claiming it was a “penalty imposed by law” which was not covered by the policy’s definition of “Loss.”[13] The court relied on its prior holding that “in the context of statutory penalties, ‘the word penalty . . . does not apply to actual damages’ but, rather, exacts sums from a wrongdoer that ‘exceed the injured party's actual damages’.”[14] As an exclusionary clause, the court was forced to adopt an interpretation favorable to the insured so long as it was reasonable. It concluded that “a reasonable insured would [understand] the term ‘penalty’ to refer to non-compensatory, purely punitive monetary sanctions.”[15]
The court’s rationale makes it clear that a key part of any settlement agreement resolving an SEC investigation should be the classification of any payments made. The labels and descriptions for each payment can determine whether there is any hope of reimbursement from an insurer.
Conclusion
Asserted liability, which runs the gamut from negligent misrepresentation to fraud with or without criminal act claims, may trigger a defense under D&O, E&O, and CGL policies. It all depends on the fact allegations as well as extrinsic evidence (including facts available to the insurer) where the law applicable to the coverage dispute permits reference to these materials. Absent an adjudication of liability for the latter conduct, that is either uninsurable under the policy language, or barred by public policy statutes, a defense duty arises for such claims.
Procuring broad coverage under a number of policies is key. As is prompt notice under D&O and E&O policies, typically issued on a “claims made and reported” basis. Late notice under a CGL policy, even absent prejudice to the insurer, may bar recovery of pre-notice defense fees (depending again on the law forum).[16] Expert coverage counsel can assist in both evaluating options for coverage[17] in the event of an ongoing investigation as well as securing necessary policies as a prophylactic measure.[18]
*David A. Gauntlett is a principal of Gauntlett & Associates and represents policyholders in insurance coverage disputes regarding intellectual property, antitrust, and business tort claims, as well as in the underlying actions. Mr. Gauntlett can be reached at (949) 553-1010 by voicemail or dag@gauntlettlaw.com. For more information, visit Gauntlett & Associates at www.gauntlettlaw.com.
[1] For more information on the potential for coverage of fees and costs incurred during this informal investigatory phase, see David A. Gauntlett, Directors & Officers Coverage for Government Investigations, https://www.gauntlettlaw.com/news/directors-amp-officers-coverage-for-government-investigations (April 28, 2022).
[2] Allstate Ins. Co. v. Interbank Fin. Servs., 215 Cal. App. 3d 825 (1989).
[3] Id. at 828.
[4] Id. at 830–31.
[5] Id. at 831.
[6] USA Gymnastics v. Liberty Ins. Underwriters, Inc., 27 F.4th 499, 509 (7th Cir. (Ind.) 2022). Willful conduct is also often excluded from coverage by state law. See, e.g., Cal. Ins. Code § 533 (bars indemnification of willful acts defined to include as actions undertaken with an intent to harm).
[7] USA Gymnastics, 27 F. 4th at 521.
[8] Id.
[9] Id. at 517, 525; see also Pendergest-Holt v. Certain Underwriters at Lloyd’s of London, 600 F.3d 562, 572–73 (5th Cir. (Tex.) 2010).
[10] Twin City Fire Ins. Co. v. SLRA Inc., No. 19-cv-06131-JSC, 2020 U.S. Dist. LEXIS 99255, *9 (N.D. Cal. June 5, 2020).
[11] J.P. Morgan Sec. Inc. v. Vigilant Ins. Co., 162 N.Y.S.3d 851 (2021).
[12] Id. at 854.
[13] Id. at 855.
[14] Id. at 856.
[15] Id. at 858.
[16] Seven forums (Puerto Rico, Michigan, Massachusetts, Maryland, New York, South Carolina, and Washington) make the coverage trigger the filing of a lawsuit, not notice to the insurer
[17] David. A. Gauntlett, Why Policyholders Should Retain Insurance Coverage Savvy Counsel, https://www.gauntlettlaw.com/news/why-policyholders-should-retain-insurance-coverage-savvy-counsel (Jan. 5, 2023).
[18] Obtaining coverage after a suit is brought is more difficult, but still possible in some situations. See David A. Gauntlett, Lawsuits Filed Prior to Policy Inception May Still Be Covered, https://www.gauntlettlaw.com/news/lawsuits-filed-prior-to-policy-inception-may-still-be-covered (July 13, 2023).