Offering Underwriter’s Section 11 Settlement Held Covered "Loss"
In an earlier post (here), I discussed the March 14 , 2007 ruling (here) in the CNL Resorts case, in which the federal district court held that an issuing company’s settlement of a claim under Section 11 of the Securities Act of 1933 did not constitute covered "loss" under the company’s D & O liability insurance policy. In that prior case, the court did say that Section 11 settlements are not per se uninsurable, and noted that "in a Section 11 case, if an entity makes a payment that constitutes something other than disgorgement of its ill-gotten gains, it has suffered a loss."
An example of the kind of Section 11 settlement that would be insurable emerged in a December 19, 2007 decision in the Mecklenberg, N.C., Superior Court case captioned Bank of American Corporation v. SR International Business Insurance. A copy of the decision can be found here. The case involves an insurance coverage dispute between the Bank and one of the "follow form" excess insurers on its program of Professional Service liability insurance.
The Bank had been sued, along with other offering underwriters, in connection with its provision of underwriting services to WorldCom for two of WorldCom’s bond offerings. The underlying complaint alleged that the offering underwriters had violated Sections 11 and 12 of the ’33 Act for not making a reasonable investigation as to the validity of WorldCom’s registration statement and failing to include material facts. The Bank ultimately settled the claim in the WorldCom litigation for $460.5 million. The Bank sought to have the carriers in its program of Professional Service liability insurance pay or reimburse the settlement amount. According to the court, "the other carriers involved paid all or a substantial portion of the claims asserted by the Bank."
The "follow form" excess carrier in the North Carolina coverage case contested its obligation to fund the settlement under its policy on a number of grounds, including, in particular, on the grounds that the Bank’s settlement of its Section 11 liability did not constitute covered "loss" under the policy. (I do not discuss in this post the other grounds on which the excess carrier contested coverage.) The parties filed cross-motions for summary judgment, which included cross-motions on the question whether the Section 11 settlement was uninsurable as a matter of law.
The excess insurer first argued that "the public policy of North Carolina would not permit insurance coverage claims under Section 11 and Section 12," a position that the court found to be "without merit." After first pointing out that the insurer could cite "neither statutory authority nor judicial decision in North Carolina holding that claims under Section 11 are uninsurable," the court observed that "it is unlikely that the appellate courts would relieve an insurer of liability for claims arising out of coverage that the insurer actively sought to write based on an argument that it was bad public policy for the insurer to write that coverage." (With respect to the latter point, the court added a footnoted observation that the other carriers in the bank’s insurance program had paid the claims asserted by the Bank for Section 11 losses.)
The Court then went on to distinguish the cases on which the excess insurer sought to rely, the CNL Hotels & Resorts case and the prior Level 3 Communications case. In distinguishing these cases, the court noted that the insureds involved in those cases were issuers of securities that had been the recipient of money from the plaintiffs in the underlying action; that the courts in each of those cases had held that "loss" did not include restoration of ill-gotten gain; and that the plaintiffs in the underlying cases involving those insureds were trying to recover the money that the issuer/insured had received as a result of the misrepresentations.
The court said that, by contrast, in the underlying WorldCom litigation, there was "no claim that seeks restitutionary damages," but that rather the "damages sought were for losses resulting from negligent performance of the underwriters’ duties." Accordingly, the court held that, because the damages sought in the underlying case were for negligence rather than the return of ill-gotten gain, "the Bank is entitled as a matter of law to judgment that the amounts the Bank paid to settle the claim against it…are ‘losses’ as defined in its liability insurance policy."
The court’s holding provides some context for the CNL Hotels & Resorts court’s statement that not all Section 11 settlements are per se uninsurable, and it also supports the view that, whatever else may be said, there should be no prohibition for the insurance of Section 11 settlements for persons other than the issuer. The arguable prohibition against the insurance for the recovery of ill-gotten gains may extend to the issuer, but in any event does not apply to Section 11 settlements on behalf of offering underwriters.
The more interesting aspect of the court’s ruling is its observation about the North Carolina’s public policy as relates to Section 11 settlements, and in particular its statements about the unlikelihood that the State’s appellate courts "would relieve an insurer of the liability for claims arising out of coverage the insurer actively sought to write." The court’s analysis in this regard turns on its head the analysis that other courts have followed in examining the question; the other courts have focused on the unfairness of the insured recovering insurance to compensate for its return of ill-gotten gain. By contrast, the North Carolina court focused on the unfairness of relieving the insurer of its obligation to pay, particularly given that the insurer sought to write that class of business.
It is perhaps some indication of what the parties to liability insurance transactions actually expect (as opposed to the lawyers that represent them in subsequent claims) that, in the wake of the CNL Hotels & Resorts case, virtually every D & O insurance carrier has rushed to market with proposed policy language specifying that the carrier will not take the position that the insurance of Section 11 and Section 12 settlements, and even judgments, are against public policy or otherwise not covered under the policy. Everyone on the transaction side of the business, at least, recognizes that there would not be much utility to the insurance if it didn’t cover Section 11 settlements. But while the introduction of the customized Section 11 coverage language may eliminate these disputes going forward, there are still an untold number of claims out there that involve policies that lack the new language. Courts will continue to wrangle with these issues for some time to come.
In light of this possibility for further disputes on this issue, it is worth observing that once again in the Bank of America case we have a situation where a "follow form" excess insurer resisted coverage even though the underlying carriers paid. I do not mean to suggest that the excess carrier in the Bank of America case did anything improper; its lawyers were protecting its interests as they saw appropriate based on existing case law. But as I have previously noted (most recently here), disputes involving "follow form" excess carriers are becoming all too frequent and threaten to become a virtually standard part of the D & O claims process.. As a result of increasing average and median claims severity, excess insurance is becoming an increasingly important part of the D & O claims process, so these issues are likely to become increasingly more critical.
I note in closing that at the upcoming PLUS D & O Symposium (about which refer here), one of the panel topics will be "Excess D & O Insurance: What’s Up With That?" Perhaps this panel will be a start on the industry’s efforts to address the excess insurance issues.