Expert Commentary

Policy Limitations on Coverage: A D&O Trend in a Hard Market

D&O insurers appear to be denying coverage more frequently now than in the soft market, relying on the personal profit, fortuity, and insurable loss arguments. Recent case law and judicial concern over corporate governance are discussed.


Professional, D&O, and Fiduciary Liability
April 2003

A hard insurance market reveals itself in various ways. The current hard market for directors and officers (D&O) liability insurance began in early 2002, initially showing itself in the form of higher premiums. Since then, insurers have narrowed the scope of the insurance policy, eliminating securities entity coverage and tightening exclusions and definitions. According to a recent survey by the Council of Insurance Brokers and Agents, there is a perception that insurers are denying coverage more frequently now than in the soft market of 3 years ago, when insurers, determined to keep client goodwill, decided close coverage issues in favor of insureds. See "Controller's Report," 2003 WL 2187201 (April 1, 2003).

Whether this perception is accurate or not, D&O insurers do appear to be challenging with increasing frequency coverage for securities fraud suits, typically relying on the personal profit exclusion, the "fortuity" doctrine, or the absence of an insurable "loss" to avoid coverage. These challenges are likely attributable to the sharp increase in the number and severity of securities fraud claims since the passage of the Private Securities Litigation Reform Act of 1995 (PSLRA).

Although Congress enacted the PSLRA to eliminate "strike suits" and to reduce securities litigation costs, the number of securities fraud suits filed annually increased in the 5 years following the PSLRA's enactment, rising from 108 in 1996 to 488 in 2001. See Securities Class Action Case Filings, 2002: A Year in Review,Cornerstone Research. Meanwhile, average settlements have increased from $7.8 million for pre-PSLRA cases to $24.9 million for post-PSLRA cases, and the median settlement has increased from $4 million for pre-PSLRA cases to $5.5 million for post-PSLRA cases. See Laura E. Simmons, Post-Reform Act Securities Lawsuits: Settlements Reported Through December 2001, Cornerstone Research.

At the root of these challenges seems to be insurers' longstanding aversion to insuring intentional corporate wrongdoing and illegal corporate profiteering. This moral hazard is "the danger that the insured will be induced by the fact that it has insurance to commit the act against which it has insurance and thereby escape the cost of the act while reaping its benefits." (See Richard Posner, "An Economic Theory of Criminal Law," 85 Columbia Law Review 1193, 1203, no. 20 (1985).)

Implicit in the concept of insurance is that loss is only insurable if it is fortuitous, that is, not planned, intended, or anticipated. (Couch on Insurance 3d, §101:1.) Because only those risks beyond the control of the insured should be eligible for coverage, D&O policies typically exclude deliberate or intentional conduct. Similarly, as D&O insurance is not intended to cover losses stemming from the disloyalty of corporate officials, most D&O policies exclude coverage where an insured "in fact" gains some profit, remuneration, or advantage to which it was not legally entitled.

Recent D&O Insurance Litigation on the Personal Profit Exclusion

The recent cases concerning the applicability of the personal profit exclusion to securities fraud suits have produced mixed results for insurers. For the most part, these recent cases have turned on whether the insurer could provide sufficient evidence that the insured derived some illegal financial benefit.

In Bogatin v Federal Insurance Company, No. 99-4441, 2000 WL 804433 (ED Pa June 21, 2000), the court, after a 3-day bench trial, found that an "in fact" personal profit exclusion barred coverage for four securities class action lawsuits. In the underlying lawsuits, plaintiffs alleged that the directors and officers engaged in securities fraud, in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and the Securities and Exchange Commission (SEC) Rule 10b-5, and insider trading.

Based on its factual finding that the directors and officers gained illegal profits from the sale of certain stock, the court applied the personal profit exclusion. Interestingly, the court found numerous other grounds on which the insurer could avoid coverage, including material misrepresentations in the insured's application that warranted rescission of the policy.

In Alstrin v St. Paul Mercury Insurance Company, 179 F Supp 2d 376 (D Del 2002), however, the court refused to apply an "in fact" personal profit exclusion to securities fraud claims against insured directors and officers. The Alstrin court distinguished Bogatin, noting that Bogatin involved, in addition to allegations of securities fraud, allegations of theft and insider trading, whereas the complaints at issue in Alstrin did not include any theft or insider trading allegations. The court flatly rejected the insurer's argument that allegations of securities fraud were sufficient to trigger the exclusion, adding that such a broad interpretation of the personal profit exclusion would "swallow up the very securities coverage the National Union policy purports to grant." (Id. at 401.)

More recently, a D&O insurer successfully argued that a personal profit exclusion precluded coverage for a suit by a bankruptcy trustee to recover the proceeds of a sham stock transaction. Nichols v Zurich American Insurance Group, 2003 WL 354686 (D Colo, Feb 7, 2003), involved allegations that the insured's directors and officers formed a putative private placement of company stock in order to raise money for themselves. The court found, as a matter of fact, that the $395,000 the directors and officers retained from the sham transaction constituted a personal profit excluded by the personal profit exclusion.

In so finding, the court cited evidence showing the company was in financial disarray and that, to save the corporation, the directors and officers applied for a loan that ultimately was conditioned on terminating their salaries. According to the court, the sham transaction was devised to obtain cash to replace their lost salaries. Having found that the directors and officers received a profit as a result of their scheme, the personal profit exclusion applied. The court noted that the clear purpose of the exclusion is "to prevent the looting of corporate assets by directors and officers and then, after being forced to remit the funds, turning to the insurer seeking indemnification for their wrongful acts...." (Id. at *12.)

Recent D&O Insurance Litigation Challenging Fortuity

A number of states, by statute or common law, recognize public policy limitations on insuring intentional conduct. Perhaps most well known is California Insurance Code Section 533, which provides that "an insurer is not liable for a loss caused by the willful act of the insured." This language is implied into every insurance contract. (California Cas. Mgmt. Co. v Martocchio, 11 Cal App 4th 1527 (Cal App 1992)).

Montana also has a statute rendering void, as against public policy, any contract by which a person seeks to exempt himself from responsibility for violation of the law or willful injury. Mont. Code Ann. §28-2-702. Montana and a few other states, including Florida and Virginia, exclude coverage for intentional wrongdoing under common law. See Enron Oil Trading & Transp. Co. v Underwriters of Lloyd's of London, 47 F Supp 2d 1152, 1166 (D Mont 1996), aff'd in part & rev'd in part, Enron Oil Trading & Transp. Co. v Walbrook Ins. Co., 132 F3d 526 (9th Cir 1997).

Two cases illustrate some of the issues that can arise when an insurer attempts to avoid coverage under Section 533 for securities fraud claims. In Raychem Corp. v Federal Ins. Co., 853 F Supp 1170 (ND Cal 1994), the insured sought coverage under its D&O policy for the settlement and defense costs incurred in a securities fraud action. Raychem shareholders sued Raychem and its directors and officers for common law fraud, negligent misrepresentation, violations of state statutes, and violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.

In their Section 10(b) claim, the shareholders alleged that the individual defendants misstated Raychem's earnings and prospects to permit the conversion of their Series B stock into common stock, which was permissible only if Raychem's performance reached certain target levels. Allegedly, the individual defendants artificially "inflated Raychem's reported income ... by various manipulative devices including the postponement of and failure to record expenditures, improper capitalization of costs that would otherwise be recorded as expense, [and] the shipping of merchandise as much as 6 months before the scheduled shipping date and improperly recording revenues from such shipments...." (Id.)

The case ultimately settled—although, at the time of the settlement, only the Section 10(b) claim remained pending. Citing Section 533, Federal refused to indemnify Raychem for the settlement. Raychem then filed coverage litigation against Federal, seeking full indemnification for the settlement and defense costs.

In granting summary judgment to Raychem in the coverage action, the court explained that the insurability of the Section 10(b) claim depended on the meaning of scienter under Section 10(b). (Id.) Because the Ninth Circuit had previously held that recklessness could constitute scienter under Section 10(b), the court concluded that Section 533 does not per se bar insurance coverage for Section 10(b) claims. The court observed that the term "willful" as used in Section 533 has a limited meaning, encompassing only acts performed with a "preconceived design to inflict injury." (Id. at 1179-80.) The court suggested that if the insurer had presented evidence showing the managers made knowing misrepresentations, it might have been able to raise a genuine issue of material fact as to willfulness, and, thus, insurability, under Section 533.

In California Amplifier, Inc. v RLI Insurance Company, 94 Cal App 4th 102 (Cal App 2001), review denied, 2002 Cal LEXIS 698 (Cal 2002), the court held that Section 533 precluded coverage under an excess D&O policy for the settlement of a market manipulation class action claim under California Corporations Code Sections 25400 and 25500. Section 25400 prohibits false statements designed to manipulate the securities market, and Section 25500 creates the private remedy for that section.

The class action complaint alleged that the insured, California Amplifier, and its officers exaggerated future demand for its products to inflate the company's stock price. The class action settled, with the primary insurer and another excess insurer paying a portion of the settlement. When RLI denied coverage, California Amplifier filed a coverage action against RLI. RLI moved for judgment on the pleadings on the ground that the securities fraud alleged was uninsurable under Section 533. The trial court granted RLI's motion, and California Amplifier appealed.

As in Raychem, the court decided the insurability of the settlement turned on the requisite level of scienter. The court noted that section 25500 expressly limits liability to willful participation in any act or transaction involving a "knowingly false statement made with the deliberate intent to manipulate the price of a security." (Id. at 111 (emphasis added).) Accordingly, the court ruled that section 533 precluded coverage.

The court distinguished the section 25500 claims—for which recklessness would not be sufficient scienter—from the Section 10(b) claim at issue in Raychem, for which recklessness could be sufficient scienter. (Id. at 117.) Thus, Raychem provides inferential support and California Amplifierprovides direct support for the proposition that an insurer may avoid liability for a settlement, on public policy grounds, where the settled claims may be established only by a showing of deliberate conduct expected or intended to cause damage.

Recent Litigation over Insurable Loss

Insurers have also recently argued, with success, that public policy sometimes bars a corporation sued under Sections 10 and 11 of the Securities Exchange Act of 1934 from obtaining coverage for the settlement of those claims. This argument is based on the principle that a settlement that merely returns an amount improperly obtained by the insured—an "ill-gotten gain"—should not be a covered loss. See Central Dauphin School District v American Casualty Co., 426 A2d 94 (Pa 1981).

In two recent cases, insurers were able to persuade courts that settlements of liability asserted under Sections 10 and 11 were restitutionary in nature and, thus, not insurable. In the Section 10 case, Level 3 Communications, Inc. v Federal Insurance Company, 272 F3d 908, 910-912 (7th Cir 2001), the underlying plaintiffs alleged that the insured made material misrepresentations that induced plaintiffs to sell stock to the insured for artificially low consideration. Plaintiffs sought to recover the difference between the value of the stock at the time of trial and the price they had received for the stock from the insured.

In the coverage action, the Seventh Circuit held that the $11.8 million settlement payment by the insured to plaintiffs was not loss under the subject directors and officers (D&O) liability policy. While the court acknowledged that plaintiffs' remedy could be characterized as "damages," the court also observed that the insured incurred "no loss within the meaning of the insurance contract by being compelled to return property that it had stolen, even if a more polite word than ‘stolen' is used to characterize the claim for the property's return."

More recently, in an unpublished opinion, Conseco, Inc. v National Union Fire Insurance Company, 2002 WL 31961447 (Dec 31, 2002), an Indiana Circuit Court upheld an excess D&O insurer's denial of coverage for the $81.84 million portion of a securities litigation settlement paid to compromise the insured's alleged liability under Section 11. Following the Seventh Circuit's reasoning in Level 3 Communications, the court found that the settlement a payment "representing the disgorgement of profits to which insured corporation was never entitled."

Will This Trend Continue?

Whether insurers will continue to challenge coverage on these grounds remains to be seen, but in the current legal and economic climate, it seems likely they will. Financial crises at many major corporations—most notoriously Enron, Tyco, and WorldCom—have spurred renewed concern about the integrity of corporate management. In response, Congress passed in 2002 the Sarbanes-Oxley Act, an unprecedented attempt to impose federal standards on corporate governance.

Courts, too, have recently expressed concerns about corporate governance, which suggests judges may more closely scrutinize corporate decisions and financial reporting in future cases. See Heightened Scrutiny for Executive Pay, ABA Journal e-Report, March 7, 2003. In this environment, judges may also be more receptive to arguments that D&O policy terms and public policy limit coverage for intentional corporate wrongdoing.


Ellen D. Jenkins is an associate with the Chicago office of Boundas, Skarzynski, Walsh & Black, LLC. Her practice focuses on directors' and officers' liability insurance, and she regularly represents insurance companies in complex insurance coverage disputes. Ms. Jenkins received her B.A. and J.D. from The College of William & Mary in Williamsburg, Virginia, and she is admitted to practice before the United States District Court for the Northern District of Illinois and in the state courts of Illinois and Maryland.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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