In his Drafting and Interpreting Insurance Policies column, Ken Wollner looks at a new California court case examining D&O conduct exclusions.
An insurance policy is a flexible mechanism for regulating legal relationships. Most of the rules discussed in this series of articles are merely presumptions about the intent of the parties to the insurance contract that can be overcome by effective drafting.
However, the ability of an insurance company and a policyholder to enter binding contract terms is limited by public policy embodied in statutory, administrative, or common law. Public policy trumps expressed terms of a contract. If a court finds that a contract provision contravenes public policy, the court may refuse to enforce the provision or, sometimes, modify the provision.
A prized feature of a most directors and officers liability (D&O) policies entitles an insured to coverage even when a claim alleges specific fraudulent intent or other wrongful acts that may fall within a conduct exclusion. There are two popular versions. Under the stronger provision, the exclusion does not apply unless a judgement or final adjudication adverse to the insured establishes the excoriating conduct. Another variant requires that the wrongful act set forth in exclusion exist "in fact."
Why are the qualifications to the conduct exclusion so important? For a publicly traded corporation, the main reason is the threat of a lawsuit predicated on violation of the securities laws. A violation of Section 10-b requires reckless, knowing, or intentional misconduct, collective referred to as "scienter." In most 10-b actions, security holders allege intentional and knowing misconduct, but such allegations are not proven. In such a case, a final adjudication or in-fact qualification to an exclusion of coverage for claims of knowing and intentional misconduct should preserve coverage because the possibility is left open of liability under the recklessness standard.
For a D&O insurance expert explaining the benefits of a good D&O insurance program, the final adjudication or in-fact qualifications to the conduct exclusions is mantra. However, a decision handed down in December 2001 by a California appellate court calls the enforceability of the qualifications into question based on public policy.
A Tale of Two Statutes
California Amplifier, Inc. v RLI Insurance Co., 94 Cal App 4th 102, 113 Cal Rptr 2d 915 (2001), arose out of a typical securities class action. The company and two of its executives were named as defendants in a suit alleging that the defendants exaggerated the future demand for the company's products as part of a scheme to raise the price of the company's stock. The complaint stated that members of the class purchased the stock at prices that were artificially inflated by the false statements. The suit was settled under terms obligating the company to pay a substantial but undisclosed amount of money to the class action members.
American Alliance Insurance Company underwrote the primary D&O policy. The primary and an excess insurer paid a portion of the settlement. However, another excess insurer, RLI Insurance Co., denied coverage and refused to comply with a demand to contribute to the settlement.
The company brought an action against RLI, asserting the usual litany of complaints: breach of contract, bad faith, and unfair business practices. RLI moved for judgment on the pleading, arguing that liability for the securities fraud violations alleged in the underlying class action were uninsurable under California Insurance Code Section 533.1 The trial court granted RLI's motion, and the Second District Court of Appeal affirmed.
For many years, insurance companies have invoked Section 533 to avoid coverage for liability claims. Section 533 relieves an insurance company of any obligation to pay if the "loss is caused by the willful act of the insured." (Emphasis added) The exoneration provision has been applied in a variety of claim contexts, including employment practices liability claims.2
The suit against California Amplifier and its executives alleged securities fraud in violation of state law counterpart to 10-b of the federal statute: California Corporations Code Section 25400, subdivision (d), and 25500. Section 25400 prohibits false and misleading statements designed to manipulate the securities markets. Section 25500 provides that:
[a]ny person who willfully participates in any act or transaction in violation of Section 25400 shall be liable to any other person who purchases or sells any security at a price which was affected by such act or transaction for the damages sustained by the latter as a result of such act or transaction. (Emphasis added)
Judge Peren, writing for the Second District panel, framed the main issue as follows: Does the theory of the underlying complaint require more than the negligence standard of recklessness? Judge Peres discussed Subdivision (d) of Section 25400, but noted that in order to prevail in a private securities action, a plaintiff must also satisfy the criteria set forth in Section 25500. Following a technical discussion interpreting the language of the statute, the court concluded an essential element of a Section 25500 violation is a knowingly false statement made with deliberate intent to manipulate the price of a security.
To complete its analysis, the court had to determine whether its interpretation of Section 25500 satisfied the criterion for application of Insurance Code Section 533. California courts have split on the question of whether the Section 533 exonerates the insurance company only when the insured subjectively intended harm or whether, in addition, such intent may be inferred from the nature of the act itself. The California Amplifier court chose the later interpretation.
While not articulated in the opinion, it is well established that harm to the market is inherent in artificial manipulation of the price of a security. Accordingly, the court concluded that Section 533 precluded insurance coverage of Section 25500 liability.
Impact of California Amplifier
In an ironic twist, the California Amplifier court cited Raychem Corp. v Federal Ins. Co., 853 F Supp 1170 (1994). This U.S. district court decision (ND Cal) has been relied on for years for the proposition that Section 533 does not apply to typical 10-b-5 actions. The court found support for its holding in a statement of the obvious in the Raychem opinion: Insurance Code Section 533 might relieve an insurer from coverage responsibility if it can be established that the insured made knowing misrepresentations.
According to Judge Peres, this dicta "provides inferential support for the conclusion that Insurance Code Section 533 would preclude coverage of Section 25500 liability which is necessarily based on knowingly false statements." It warrants emphasis that the California appellate court did not endorse the Raychem holding.
The usefulness of California Amplifier for D&O insurers faced with a demand for payment of defense costs and indemnity in a California securities action is limited. Under the Uniform Standards Act signed into law by President Bill Clinton on November 3, 1998, the federal securities laws, for the most part, supercede state securities laws with regard to class actions. Nonetheless, California Amplifier provides a clear basis for denial of coverage for a claim based solely on a state court lawsuit alleging violations of Sections 25400 and 25500 of the California Corporation Code. Even if a D&O insurer does not deny coverage, the existence of the precedent can, under the right circumstances, be used as the basis for allocation and to lower plaintiff's expectations in settlement discussions.
In a broader context, the possibility of a coverage defense based on public policy against indemnity for a willful act looms larger because of California Amplifier. The willful act coverage defense can still be invoked for some nonsecurity claims, such as antitrust and deceptive trade practice complaints. Furthermore, a few other states have a statute prohibiting enforcement of contracts that shift responsibility away from the wrongdoer. For example, Section 9-08-02 of the North Dakota Code provides that:
[a]ll contracts which have for their object, directly or indirectly, the exempting of anyone from responsibility for his own fraud or willful injury to the person or property of another, or violation of law, whether willful or negligent, are against the policy of the law
Section 26-06-04 states that "[a]n insurer is not liable for a loss caused by the willful act of the insured."
A subplot in the Enron litigation reminds us that legislation explicitly prohibiting indemnification of wrongdoers for the consequences of their intentional acts is not the only source of public policy. A motion by Enron requested that the Bankruptcy Court for the Southern District of New York approve and authorize advancement of defense costs under the primary D&O and ERISA/Fiduciary policies.
An eclectic group opposed the motion, including Jesse Jackson's Rainbow Coalition and 33 state attorneys general, lead by Oregon's Hardy Myers. The objection on behalf of Attorney General Myers argued, in part, that until the directors have provided the affirmation required by Oregon law of their good faith belief that their conduct was not unlawful or opposed to the best interests of the corporation, they cannot receive advance payment of costs.3 Enron is incorporated in Oregon.
The denouement of this drama included an explanation by Bankruptcy Judge Arthur Gonzales of why he would neither grant nor deny the motion. According to a report in The Washington Post,4 "Gonzalez said it was not his place to tell insurance companies how to fulfill their obligations to Jeffrey Skilling, Andrew Fastow, and other current and former top Enron officials facing government investigations and civil lawsuits."
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.
Myers also urges the court to reject Enron's motion until the civil and criminal liabilities of the Enron directors have been determined. According to the objection, Oregon law mandates indemnification only when a director has been "wholly successful on the merits" and such a resolution is "far from certain." Joiner of the State of Oregon in Objection by Florida State Board of Administration of Debtor's Motion for an Order Authorizing and/or Approving Direct Payment and/or Advancement of Defense Costs to Individual Defendants.