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Second Circuit Rules for Broader D&O Coverage of Securities Claims

Tuesday, July 12, 2011

Cherilyn Zavatsky | Bloomberg Law MBIA Inc. v. Federal Insurance Co., No. 10-CV-00355, 2011 BL 174746 (2d Cir. July 1, 2011) The U.S. Court of Appeals for the Second Circuit held that MBIA Inc.’s (MBIA) directors and officers (D&O) insurance policies covered the investigative costs incurred in responding to Securities and Exchange Commission (SEC) and New York Attorney General (NYAG) subpoenas. This is the first time an appeals court has ruled to provide such broad coverage of securities claims.

SEC and NYAG Investigations; Shareholder Derivative Suits

On March 9, 2001, the SEC issued a formal order of investigation into certain insurance companies’ compliance with federal securities laws and proper accounting practices. Financial guaranty insurer MBIA was one of the investigated companies. In November 2004, the SEC issued a number of subpoenas to MBIA that required the production of information related to “Non-Traditional Product” transactions and inquired into accounting transactions. The NYAG issued similar subpoenas during the same month. The investigations resulted in regulatory scrutiny of three transactions: (1) reinsurance purchased for MBIA’s guarantee of bonds issued by Allegheny Health, Education and Research Foundation (AHERF); (2) MBIA’s purchase of an interest in Capital Asset Holdings GP, Inc. (Capital Asset); and (3) MBIA’s guarantee of securities used to purchase airplanes for US Airways. MBIA notified its D&O insurers, Federal Insurance Company (Federal) and ACE American Insurance Company (ACE), of the regulatory investigations and sought their consent to incur defense costs and appoint defense counsel. The policies provided a total of $30 million in coverage, with a $200,000 sublimit for shareholder derivative claims. The insurers determined that the subpoenas did not trigger coverage, but recognized them as notice of a potential claim. MBIA later sought consent to settle with the regulators who had threatened to take action against it in August 2005. Following completion of the investigation of the AHERF transaction, MBIA signed a preliminary offer of settlement with the SEC and NYAG for the federal and state claims. Because the investigation of the Capital Asset and US Airways transactions had not yet been completed, the regulators agreed to allow an independent consultant (IC), paid by MBIA, to continue to review them. MBIA notified Federal and ACE of the IC in September 2006. MBIA also entered a settlement agreement in late January 2007, related to the AHERF transaction, that contained a provision for IC review of the Capital Asset and US Airways transactions. The IC ultimately exonerated MBIA for those transactions. In addition to the regulatory investigations, two shareholders sent a demand to MBIA asking it to file suit against its directors and officers. A “Demand Investigation Committee” (DIC) was created, but because MBIA failed to act on the demands, they were effectively rejected. The shareholders then filed two derivative lawsuits. A “Special Litigation Committee” (SLC) determined that it was not in MBIA’s best interests to maintain the derivative suits. The SLC moved to dismiss, and the lawsuits were ultimately terminated. Federal agreed to pay $6.4 million for the losses from the SEC’s investigation of the AHERF transaction and related lawsuits, which included $200,000 for the DIC investigation, but refused to cover losses related to the Capital Asset and US Airways transactions and the NYAG’s investigation of the AHERF transaction. ACE’s level of coverage was not reached. MBIA filed suit against its insurers to compel coverage of the costs from regulators’ investigations of the AHERF, Capital Asset, and US Airways transactions; the IC’s costs; and the SLC’s work. The district court granted summary judgment in favor of MBIA for the investigation and SLC costs, but found in favor of the insurers on the IC costs. The parties appealed.

Subpoenas Are Covered “Securities Claims”

The insurers’ policies provided coverage for “Securities Loss” for which MBIA was legally obligated to pay on account of a “Securities Claim.” “Securities Claim” was defined by the policies as “a formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative or similar document.” The Second Circuit agreed with the district court that the NYAG subpoenas related to the AHERF transaction were securities claims, as that term was defined in MBIA’s policies. The Court reasoned that the NYAG subpoena was at least similar to an investigative order and was backed by the enforcement authority of the state. Furthermore, the Court noted that such would be the interpretation of a reasonable businessperson. Therefore, the Court held that costs associated with the investigation undertaken in response to the subpoenas were covered under the D&O policies. The Court also held that MBIA’s response to the SEC’s and NYAG’s investigations of the Capital Asset and US Airways transactions were covered securities losses. The March 2001 formal order permitted the SEC to investigate, among other things, accounting misstatements and other similar courses of business in insurance companies. The accompanying subpoena sought documents regarding transactions meant to affect the timing and recognition of revenue or expenses. Finding that these courses of business fell within the scope of the subpoenaed “Non-Traditional Products,” the Court concluded that the formal order was sufficiently broad to encompass the Capital Asset and US Airways transactions. The Court similarly held that the NYAG’s investigation into the two transactions were covered securities losses.

Derivative Actions Covered

The insurers argued that the costs related to the SLC were not covered “Defense Costs” because (1) the SLC was not an “Insured Person,” as that term was defined in the D&O policies; (2) granting coverage would render the $200,000 sublimit for derivative claims superfluous; and (3) exclusions from the definition of “Loss” applied. The Court disagreed and held that the policies covered SLC-related costs. Regarding the insurers’ first contention, the Court reasoned that because the SLC’s actions, including the decision to move to dismiss the derivative suits, were in exercise of MBIA’s powers as granted under Conn. Gen. Stat. § 33-724(a), the SLC was an “Insured Person.” As to their second contention, the Court held that the $200,000 sublimit—the maximum liability provided in the D&O policies for investigative costs related to shareholder derivative demands—was not clearly and unmistakably established by the insurers to exclude coverage. The Court noted that, although it was not clear how investigative costs would be covered under the shareholder derivative claim coverage section of the policies after a shareholder demand is rejected and the shareholders file suit, other coverage parts clearly covered the costs of investigating “Securities Claims” or “Claims.” Those terms, as defined by the policies, expressly included lawsuits. Therefore, the Court held that the insurers did not meet their burden that the $200,000 sublimit excluded coverage. Lastly, the Court held that the policies’ exclusion from the definition of “Loss” of “any amount incurred by [MBIA] . . . in connection with the investigation or evaluation of any Claim . . . by or on behalf of [MBIA],” did not exclude coverage for the shareholders’ derivative claims. The Court reasoned that the insurers did not establish that the exclusion applied by arguing that MBIA was a plaintiff in the lawsuits, as MBIA was also a nominal defendant. Thus the “on behalf of” language in the exclusion did not clearly support their position.

Independent Consultant Costs Covered

Finally, the Court addressed whether the D&O policies covered the costs incurred by the IC. The Court, reversing the district court, held that they were. Citing the “right to associate” clauses in the Federal and ACE policies, which gave the insurers the right to associate with MBIA in the settlement of a potentially covered claim, the Court concluded that MBIA provided sufficient notice of the proposed $75 million settlement with the regulators. The Court reasoned that the IC involvement was not a separate claim for which the insurers had to be notified, but rather was a provision of the proposed settlement in which the insurers elected not to participate. Furthermore, because the insurers learned of the IC involvement well before the regulators approved the settlement in January 2007, the Court concluded that the insurers had a meaningful opportunity to associate in the settlement discussions. In addition, the Court held that the IC involvement was within the bounds of the insurers’ agreement not to raise the consent to settlement, a condition in the D&O policies, as a defense to coverage. MBIA had notified the insurers that the settlement proposal was subject to change and their silence upon the IC involvement was reasonably taken by MBIA as a continuing agreement not to raise consent to settlement as a defense to coverage. Accordingly, the Court affirmed in part and reversed in part the judgment of the district court. Disclaimer This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy. ©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.

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