By PETER S. SELVIN, a partner in the Los Angeles office of Loeb & Loeb LLP, where he practices in the areas of business litigation and insurance coverage
In the wake of the Madoff scandal, there have been increased efforts on the part of the SEC to commence investigations and to initiate civil enforcement actions against U.S. companies and their directors and officers.
This development should spur companies and their directors to consider whether the cost to respond to these efforts can be absorbed by insurance carriers who have provided directors' and officers' (D&O) liability insurance coverage.
In evaluating whether coverage under a D&O policy may exist for an SEC investigation or enforcement action, three main questions have to be addressed: Is the investigation or enforcement action a "claim" under the policy? Who is an "insured person" for purposes of such a claim? Is coverage barred by an exclusion?
The first question--whether the investigation or enforcement action constitutes a "claim" under the policy--is crucially important.
Is the governmental investigation a "claim"? While the definition of "claim" may vary depending on the particular policy, as a general matter coverage is often provided under D&O policies for an administrative or regulatory "proceeding," but not for an administrative or regulatory "investigation." In the case of SEC investigations, there is case law supporting the principle that an SEC investigation becomes a covered "proceeding" when the SEC investigation becomes "formal"--i.e., when an order is issued by the commission for an investigation, as distinguished from an informal investigation by the commission staff. In this regard, courts often distinguish between an administrative investigation which merely amounts to a request for information (for which there will not be coverage) and an investigation where the directors and/or officers are "targets" of a potential enforcement action (where there could be coverage). This is often a fact-intensive inquiry and there is no "bright line" rule in this area.
The definition of "claim" is also implicated when a company receives subpoenas from a governmental agency and incurs expenses in responding to those subpoenas. Several cases have found coverage for those expenses under D&O policies.
For example, when "claim" is defined to include demands for "monetary or nonmonetary relief," some courts have taken the view that because disobedience of a subpoena would potentially subject the insured to enforcement proceedings (i.e., a form of "nonmonetary relief"), coverage exists. In other instances, courts have equated the issuance of subpoenas by governmental agencies as tantamount to a "formal investigative order" and have found coverage on this basis.
Whatever the particular definition of "claim," however, it is often the case that governmental investigations evolve over time, with the result that an investigation which may not initially meet the definition of a "claim" may later develop into an actual "claim."
For example, in one recent case, the insured company was the subject of an SEC investigation, which escalated in scope. At the beginning, the company received a notice that the SEC had commenced an informal investigation. Thereafter, the SEC issued an order directing a private investigation and designating officers to take testimony.
Following this stage, the SEC sent Wells notices to certain of the company's officers and directors. Thereafter, the SEC issued an order to institute administrative and cease and desist proceedings against the company and administrative proceedings against one of the company's officers. Finally, the SEC filed a complaint in federal court against that officer.
The key issue in the coverage suit was at what point in this escalating process had a "claim" been asserted. The court in that case ruled that it was the SEC's commencement of a "formal investigation" that triggered coverage under the applicable policy.
Who is covered? The next major issue which has to be addressed is who is an "insured person" under the policy. In this regard, D&O policies are typically reimbursement-type policies whereby the company is reimbursed for expenses that it incurs in defending its directors or officers in respect to a claim. Typically, in the absence of some form of "entity coverage" (whereby the company is covered for expenses that it incurs on its own behalf in connection with its defense), the company is not considered to be "an insured person."
In such event, there ordinarily will be no coverage for the company where it is the target of an investigation in which it receives, for example, a subpoena or investigative demand from the SEC or other governmental agency. However, if the underlying investigation targets an individual officer or director for alleged wrongdoing, then depending on the policy's definition of "claim," the costs associated with that individual's response to such investigation could be recovered under a D&O policy.
What is excluded? Several kinds of exclusions may come into play when a company seeks coverage for costs associated with an SEC or other governmental investigation.
At the outset, while counsel fees associated with an investigation could (assuming there were coverage in the first instance) be considered "defense costs" and hence subject to reimbursement, there would be no coverage for any administrative fines or penalties that might be assessed as a result of such an investigation. In addition, if the company or its officers or directors were ordered to disgorge ill-gotten gains, such as profits from insider trading, those payments would typically not be reimbursed under a D&O policy. Neither fines nor penalties, or amounts paid by way of restitution, are covered because the definition of "loss" in such policies typically is limited to "damages" and "defense costs."
D&O policies may also have so-called "regulatory exclusions," whereby the costs associated with governmental investigations expressly are excluded from coverage. Such exclusions are the "flip-side" of insuring clauses in policies that expressly cover the costs associated with governmental investigations.
Finally, there are a series of "conduct exclusions" that are typically found in D&O policies. These exclusions bar coverage in a variety of circumstances--such as when a director or officer is found to have engaged in fraud or dishonesty, or when the director or officer has gained a "personal profit or advantage" to which they "were not legally entitled." (The latter exclusion comes into play when, for example, insider trading is at issue.)
The good news, from an insured's perspective, is that in modern D&O policies these "conduct exclusions" usually are triggered only when there has been an actual finding or adjudication that an insured person in fact engaged in specific conduct.
There are several strategies which companies and their counsel can use to maximize coverage for SEC and other governmental investigations.
Give notice immediately. D&O policies typically contain a "consent" clause which provides that the carrier will not be liable for defense costs to which it has not consented. Put simply, companies will not generally be able to recover defense costs or attorneys fees that have been incurred prior to their giving notice to their carrier.
Give further notice as the governmental investigation evolves. As noted above, an investigation which initially fails to meet the definition of a "claim" may ultimately evolve into an actual "claim" that is covered by D&O insurance. Thus, companies should continue to keep their D&O carriers apprised of developments in the investigation and continue to press for coverage as that investigation changes and evolves.
Demonstrate that counsel's efforts in defending an administrative investigation have assisted in the defense of parallel civil actions. Civil actions often follow on the heels of SEC or other governmental investigations. Because there frequently is an overlap between administrative and litigation proceedings, counsel for a company that is the subject of an SEC investigation ought to be prepared to demonstrate how their efforts have assisted in the defense of the parallel civil actions. In this regard, there is case law to the effect that coverage will be found for the cost of SEC and grand jury investigations when counsel's efforts in defending those actions were found to serve the company's interests in defending a parallel civil action.
Purchase a D&O policy that expressly covers SEC or other governmental investigations. To avoid uncertainty, a company might consider purchasing a policy which specifically covers SEC investigations. There are, however, at least two trade-offs to this approach.
First, such coverage is expensive, as governmental investigations (especially those that have not reached the "formal" investigative stage) may not otherwise be covered under typical D&O policy provisions.
Second, such coverage may not necessarily be in the interests of the company's directors and officers, as such coverage could well erode the limits of available coverage for those directors and officers in the event that both a covered litigation and SEC investigation occur within the same policy year.
Editor's Note: This article was first published in the August/September issue of Executive Counsel.
October 15, 2010
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