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Though it may seem reasonable that liability insurance should not compensate an insured who must pay back money that the insured should not have had in the first place--especially money obtained through fraud or theft--applying this principle can be confusing and controversial.

Directors' and officers' and errors & omissions carriers routinely reserve their rights to deny coverage for settlements or damages payments that they claim represent "disgorgement" or "restitution," and sometimes they deny coverage on these grounds. Policyholders respond that the payment of damages and settlements is a central reason for their purchase of liability insurance.

The issues are especially difficult because in many cases, even if plaintiffs seek disgorgement or restitution, they often also allege other theories of recovery, and because many cases settle without any determination or acknowledgement that the settlement payment represents disgorgement of ill-gotten gain.

Carriers raise the disgorgement issue frequently and corporations and their directors and officers must be prepared to address it. They have good arguments that the disgorgement coverage defense, which is based on "public policy," should be applied in limited circumstances.

Insurers rely heavily on Level 3 Communications Inc. v. Federal Insurance Co., but policyholders may argue that this is a very flawed decision. In that case, former shareholders of MFS Telecom, had sold the company to the defendant, Level 3 Communications. But MFS shareholders later sued Level 3, claiming that it had wrongfully acquired their shares through fraudulent representations and omissions, and that had they known the truth they could have commanded a higher price for their shares.

Level 3 settled the lawsuit for $12 million, and then sought coverage for the settlement payment under a D&O policy issued by Federal Insurance Co. Federal denied coverage. Level 3 sued.

Reversing a lower court ruling, the appeals court held that the settlement payment constituted uninsurable disgorgement because the plaintiffs had been seeking to divest the insured of the money it unlawfully obtained. The court concluded that it made no difference that the defendant's payment was the result of a settlement rather than a judgment.

Whether or not the Level 3 court reached the right result based on the facts of the case, the method by which it got there was unorthodox. Unlike recent decisions that emphasize the need for fact-finding at the trial court level, the Level 3 court dispensed with this requirement. It simply observed that the settlement was a "not inconsiderable amount" and made after trial had started, and based on this found that the settlement operated as an admission by the defendant that it had obtained the plaintiffs' money through fraud and was disgorging part of its illicit profit.

But this critical factual determination was made by the court of appeals, not the district court, which had found that the settlement was a covered loss under the Federal policy. The appeals court's approach disregarded the fundamental principle that appeals courts should not find facts. Moreover, the court's fact-finding was seemingly ad hoc and without clear reference to any particular legal standard.

For example, its determination that the settlement represented the return of ill-gotten gain rested on its opinion that the $12 million settlement payment was a "not inconsiderable amount." But since the plaintiff was seeking almost $70 million, a $12 million settlement could just as easily be interpreted as an acknowledgment of litigation risk rather than of wrongdoing. Nor did the court cite other examples in the law where an inference of wrongdoing properly may be drawn from a settlement containing no admission of wrongdoing.

The Level 3 court also erroneously stated that "standard damages relief in a securities-fraud case" is restitutionary and therefore not insurable. This is simply incorrect and would seriously undermine D&O coverage if it were true.

THE NEED FOR FACT-FINDING

In 2006, a slew of cases addressed the issue of coverage for alleged disgorgement. There was a clear trend indicating that unless it is evident from the pleadings or at the summary judgment stage that plaintiffs seek only disgorgement of ill-gotten gain, resolving the coverage issues requires a factual record.

There may be cases where it is clear from the pleadings or at the summary judgment stage that only monetary relief that might be ordered is disgorgement. Summary judgment may be appropriate in these circumstances, though the insured still may argue that there should be coverage absent a finding that it engaged in wrongdoing or was not entitled to the profit it made. In any event, such cases probably are not typical.

Where the underlying complaint seeks damages as well as restitution, the Ninth Circuit's recent decision in Unified Western Grocers v. Twin City Insurance indicates it is important to look beyond the labels assigned to plaintiffs' claims, and that this inquiry is factual in nature and often precludes summary judgment. In that case, the Ninth Circuit held that summary judgment for the insurer was improper because a genuine issue of material fact existed as to the extent that the underlying complaint sought restitution of money wrongfully acquired. The court noted that where a judgment represents disgorgement only in part, there may be an allocation by the insurer, indemnifying only for the covered part of the loss.

Most litigation settles before trial, and coverage for settlement payments may present unique challenges to insurers, insureds, and courts dealing with the disgorgement issue. Typically there are no findings or admissions of any wrongdoing or as to which part, if any, of a settlement payment represents disgorgement of ill-gotten gain. Even when a portion of a settlement is labeled "disgorgement," a New York appellate court's recent ruling indicates that there still may be questions of fact as to what the payment actually represents.

Whether a settlement payment represents disgorgement in whole or part in many cases may seem like a metaphysical question, since settlement payments normally settle all aspects of a case. But depending on the facts of a particular case, there may be fruitful avenues of inquiry, such as the relative strength of the plaintiff's various claims for relief.

APPLICABLE PRINCIPLES

In Unified Western Grocers and Pan Pacific Retail Properties v. Gulf Insurance, the Ninth Circuit indicated that the type of loss that should be deemed noninsurable is "limited" and "narrow." Insureds may argue that this is consistent with general principles of insurance law and public policy considerations, which should be taken into account in any dispute over coverage for a payment that allegedly represents restitution or disgorgement.

First, coverage for disgorgement or restitution is rarely explicitly excluded from insurance policies. Disputes typically involve insurance clauses that exclude from the definition of loss "matters uninsurable under law," and it is on this basis that insurance carriers deny coverage. Where disgorgement or restitution is not explicitly excluded, this would seem to place a greater burden on insurers to justify their exclusion. As a matter of basic insurance law, an insurer has an obligation to set forth exclusions clearly and explicitly.

Even where the exclusion is explicit, insureds may cite the black letter principle that exclusions and limitations on coverage must be construed narrowly against the insurer. Insureds might also argue that "matters uninsurable under law," is ambiguous, and therefore must be construed narrowly in favor of coverage.

The concept of a "matter uninsurable by law" rests on public policy, but insureds also could contend that it is against public policy to interpret and apply the term broadly; courts should place limits on the freedom of contract only when absolutely necessary. While it clearly is good public policy that insurance carriers need not replenish ill-gotten gains disgorged from an insured who has committed theft or fraud, many cases are not so clear--either that the insured has committed wrongdoing, or that the insured's payment represents disgorgement, or both.

In those cases insureds may argue that narrowly construing "matters uninsurable under law" is consistent with our legal system's respect for freedom of contract. Moreover, insureds may argue that the public policy coverage exception should be limited to cases involving intentional wrongdoing, such as fraud or theft.

Where the issue is coverage for settlements, insureds also may argue that there is no public policy reason to preclude coverage for settlements, at least absent clear evidence that the settlement payment, or some portion of it, represents disgorgement of gain obtained through wrongful conduct. Indeed, there is a strong public policy in encouraging litigants to settle, which arguably militates in favor of insurance coverage for settlements. And insurance carriers know when they issue their policies that most litigation settles short of judgment, and so they arguably assume the risk of coverage for settlement payments even where the insured's loss would have represented uninsurable disgorgement had the case been litigated to judgment.

For all of these reasons, insureds may argue that where there is a factual inquiry regarding coverage for a settlement, the insurer should bear a high burden of demonstrating uninsurability. Similarly, insureds may argue that summary judgment or judgment on the pleadings arguably is appropriate on the disgorgement issue only in the clearest of cases.

One final, important note on the disgorgement issue: when purchasing D&O and E&O insurance, risk managers should check with their brokers about addressing the disgorgement issue explicitly in a policy endorsement. Depending on market conditions, insurers may agree not to raise the disgorgement coverage defense in particular circumstances.

MARK S. HERSH is a partner at Reed Smith LLP and deputy practice group leader of its insurance recovery practice group.

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July 1, 2007

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