|Beware D&O Subprime Coverage (October 30, 2008)|
If you find yourself in court over subprime trouble, count on insurer resistance
Think you’re covered? Insurance carriers typically look for reasons to leave you stranded when suits like the subprime aftermath get filed. You may be fighting a two-front war
The inevitable lawsuits following the subprime mortgage aftermath have begun. Officers and directors of financial companies that think they may be sued, along with their companies, may be wondering what protection they have under their directors and officers liability policies and other coverages.
Already, suits have been filed over the course of 2008 by some of the largest institutions that became involved in the subprime world. These suits alleged that the companies and their officers issued materially false and misleading statements concerning their companies’ exposure to the subprime market. The common theme is that the company allegedly overstated its financial results by failing to disclose the true extent of its exposure to the subprime market, and thus falsely inflated the prices that investors paid for the company’s securities.
As more companies are forced to adjust their balance sheets to reflect losses arising from investments in subprime mortgages, more suits will follow.
Potential insurance coverage—and potential resistance
Once claims are brought or even threatened, a company and its officers and directors should determine what insurance policies may serve as financial protection against these claims. First, these suits typically name not only the companies as defendants, but the company’s key senior executives and officers as well. This may enable the company to tap into its directors and officers coverage and should allow the directors or officers identified in the complaint direct access to those policies. This type of coverage generally pays for losses arising out of claims made against corporate directors and officers for alleged “wrongful acts” while acting in their capacity as an officer or director of the company. Many policies also provide coverage for the company to the extent it has indemnified its corporate officers or directors, or straight “entity coverage” for certain claims made against the corporation directly, such a “securities action claim,” which should not be overlooked.
Nearly all D & O policies are issued on a “claims made” basis. This means that they only cover claims made against the directors and officers during the policy period, regardless of when the alleged wrongful acts are purported to have taken place. It is thus the timing of the suit, not the timing of the wrongful acts themselves, that determines which policy will respond to the claim. Prompt notice to the primary insurer should be provided and, if the amount sought is substantial, excess carriers should be placed on notice as well.
Given the magnitude of the losses, insurers will likely resist paying these claims and raise a host of policy-based defenses. Based on the approach taken by insurers when faced with other large-scale financial crises (such as the savings and loan crisis many years ago and the ongoing stock option backdating claims), the defenses on which the insurers will rely have been predictable.
Initially, insurers will inspect the application for insurance to determine if there were any misrepresentations, or any warranties in the application by the proposed insured, that might have been breached. For example, most applications require the proposed insured to warrant that it is not aware of any circumstances that could lead to a claim or suit. Many of the subprime lawsuits, however, allege that the company’s officers and directors were aware of the company’s risky investments and yet failed to take appropriate action to deal with the problems in the credit and housing market that were looming on the horizon.
Similarly, many applications require a company to attach a financial statement when applying for D & O insurance. Yet many of the subprime lawsuits allege that the company’s financial statements were misleading and failed to disclose the true extent of the company’s losses in its subprime portfolio. In both cases, the insurer will attempt to establish the same facts as the plaintiffs in the underlying case in order to rescind the policy.
Thus, instead of partnering with its insured to defeat the underlying suit, the insurer will likely be searching for facts that could be used to void some or all of the coverage under the policy—which may be the same facts that the underlying plaintiffs will seek to establish to prove liability against the company and its officers or directors. The insured may thus be forced to fight a two-front war, with a supposed ally—its insurer—as one of its enemies.
Some counterpoints for insureds
Coverage is typically provided in D & O policies for “wrongful acts,” which usually include “any breach of duty, neglect, error, misstatement, misleading statement, omission or act by directors or officers in their capacity as such.” Despite this broad coverage, indemnification is usually provided only for negligent acts, not intentional acts. Yet intentional acts that are done without the intention to cause harm or violate the law should be covered. Insurers will also attempt to show that the alleged misleading statements are excluded from coverage as “dishonest, fraudulent or criminal acts.” These policies generally contain a “dishonesty” exclusion, but most policies limit the exclusion to cases where “a judgment or other final adjudication” establishes the dishonest conduct. Thus, most pre-judgment settlements should not be encompassed within the exclusion, although the insurer can be expected to argue to the contrary. Nor would defense costs.
One of the most frequent areas of dispute involving D & O coverage relates to questions of allocation. Directors and officers policies cover “loss,” i.e., defense and indemnity, but only for “covered claims.” Therefore, if the suit alleges both covered and noncovered claims, or names both covered and noncovered parties as defendants, the insurer will contend that the defense and settlement costs must be apportioned among the claims and parties involved. Thus, the insurer will seek to pay only those defense and settlement costs associated with covered claims and will attempt to minimize the costs attributed to covered claims. The larger the claim, the more likely it is that a court may be forced to determine the appropriate allocation.
In addition to standard D & O policies, the same charges levied against corporate officers for their alleged mismanagement of the company’s finances and its exposure to subprime debt may also trigger coverage under the company’s professional errors and omissions policies. This type of policy typically covers a professional for negligence or malpractice arising out of the performance of “professional services.” Similarly, coverage may exist under other specialty lines of coverage, such as fiduciary liability policies.
Shoals ahead for insureds
These are but a mere sampling of the issues that are likely to arise in response to claims resulting from subprime lawsuits against directors and officers of investment banks, lending companies, and other financial institutions. If history is any guide, insurers are likely to resist paying for the defense and/or settlement of these suits, particularly given the size of the claimed losses. This may force the policyholder not only to defeat the plaintiffs in the underlying suits, but to prevail against its insurers in a coverage action. BJ
[This article was posted on October 30, 2008, on the website of ABA Banking Journal, www.ababj.com, and is copyright 2008 by the American Bankers Association.]
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