Insurance Coverage Alert
October 2007
Authors:
David T. Case
+1.202.778.9084
david.case@klgates.com
Philip H. Hecht
+1.202.778.9393
philip.hecht@klgates.com
K&L Gates comprises approximately 1,400
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growth and middle market companies,
leading FORTUNE 100 and FTSE 100
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entities. For more information, please visit
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Insurance Coverage for Governmental
Investigations of Financial Institutions
Many financial services companies are facing an unprecedented wave of scrutiny by
Congress, federal and state regulators, including the Securities and Exchange Commission
(“SEC”), state Attorneys General and other regulatory agencies as a result of the growing
crisis in the subprime lending industry. These companies will incur substantial costs in
defending against these investigations and the investigations are fraught with risk because
they also may subject a company to class actions or other private litigation.
When faced with any high-risk claim, a company should examine its insurance coverage
program to determine the coverage available to respond to that claim. By way of example,
Comprehensive General Liability (“CGL”) policies should respond to claims of property
damage, bodily injury, personal injury, and advertising injury. In addition, for financial
services companies facing a government investigation, two potentially significant forms
of coverage are directors’ and officers’ liability policies (“D&O policies”) and errors and
omissions, or professional liability policies (“E&O policies”).
While D&O policies vary, these policies afford coverage to directors and officers for
non-indemnified claims and also afford “reimbursement” coverage to the entity that is
indemnifying the directors and officers in connection with the underlying liability. In some
cases, the parent entities and their affiliates also will be covered for certain losses resulting
from claims made against an insured for a wrongful act, including any actual or alleged
error, misstatement, misleading statement, act, omission, neglect or breach of duty, if the
policy contains Entity Coverage. The Entity Coverage afforded by D&O policies issued to
publicly-traded companies typically covers securities claims involving the company’s own
securities, rather than claims arising from investments in other types of securities. Typically,
the “insured” under an E&O policy includes a professional business entity such as a banking
institution, a mortgage banking service provider, or a mutual fund complex, as well as the
individuals who provide professional services on behalf of that business entity. Often, for
large business entities, insurance carriers will package a combined D&O/E&O policy for
many reasons, including facility of use, ease of reference and, sometimes, premium savings.
If the underlying regulatory investigation is directed at securities-related issues, it is likely
that directors and officers may be implicated and, therefore, D&O coverage may be a more
likely route of recovery. If the underlying investigation is related to business operations and
the employees associated with those operations, it is likely that E&O coverage may afford
coverage for defense costs and indemnity, or the damages, associated with such matters.
Although D&O/E&O policies are usually “claims made” policies, the language of such
policies can differ considerably, including variations in the definition of such critical
terms as “Claim” and “Loss.” Accordingly, this article addresses certain key provisions in
these policies, the nature of a “claims made” policy, and some of the potential defenses to
coverage.
Insurance Coverage Alert
Investigations As Covered Claims
And The Defense Obligation
A threshold issue to coverage for a government
investigation is whether such an investigation
constitutes a covered “Claim” under the pertinent policy
language. In some D&O/E&O policies, a “Claim” is
defined broadly and includes not only formal lawsuits
and administrative proceedings, but “investigations,”
which is typically an undefined term. For example,
the following language, or a variation thereof, may be
found in some policies:
Claim means:
1. A civil proceeding commenced by the service of a
complaint or similar pleading;
2. Any formal administrative proceeding commenced
by the filing of a notice of charges, or formal
investigative order or similar document;
3. A demand; or
4. Any investigation into possible violations of law
or regulation initiated by any governmental body
or self-regulatory organization (SRO), against an
Insured for a Wrongful Act, including any appeal
therefrom. (emphasis supplied).
Under this language, the definition of a covered Claim
plainly includes investigations by any governmental
body of possible violations of law.
Once the insured determines that the investigation
constitutes a covered Claim under the definition
in its policy, a D&O/E&O policy should cover the
defense costs of responding to the investigations. This
coverage for defense costs may prove quite valuable,
as a company may need to pay millions of dollars to
defend itself against the investigations. Moreover, the
obligation to cover defense costs must be honored by
an insurer, even if regulators ultimately decide not to
bring charges or to file suit. Finally, depending on the
facts developed during the investigation, the policy
may afford coverage for any settlements or judgments
the company pays as a result of the investigations.
Although a government investigation may fall within
the ambit of a “claim,” the scope of the corresponding
defense obligation may raise issues requiring a close
review. One difference between D&O and E&O
policies is that E&O policies often include a “duty to
defend” that obligates the insurer to afford a defense
to the insured for potentially covered claims, whether
frivolous or not, even if the claim includes uncovered
matters and covered matters. A D&O policy typically
does not incorporate a right or duty to defend, but
instead operates to reimburse (or, more favorably,
advance) defense costs incurred with the “consent”
of the insurer.
The Nature Of “Claims-made”
Coverage
A critical feature of D&O/E&O policies is that they are
generally “claims-made” policies. This requirement
is typically embedded in policy language stating
that “[t]his is a claims-made policy and, subject to
its provisions, [it] applies only to any ‘Claim’ first
made against the insureds during the policy period.
No coverage exists for Claims made after the end
of the policy period unless, and to the extent, the
extended reporting period applies.” An insured may
pay an additional premium for the “extended reporting
period.” This generally allows the insured to extend
the time during which a “Claim” can be reported to
the insurer and covered under the policy, but only
for Claims based upon Wrongful Acts that took place
during the original policy period.
The Policy Definition Of Loss
D&O policies cover “Loss” resulting from certain
claims against insureds. Although the definition of
Loss can differ among policies, in some, Loss may be
defined as:
the total amount which an Insured becomes legally
obligated to pay on account of each Claim … for
Wrongful Acts for which coverage applies, including
but not limited to damages (including punitive or
exemplary damages … if and to the extent that such
punitive or exemplary damages are insurable under the
law of the jurisdiction most favorable to the insurability
of such damages provided such jurisdiction has a
substantial relationship to the relevant Insureds, to the
Company, or to the Claim giving rise to the damages),
judgments, settlements, costs and Defense Costs.
Yet under certain definitions of Loss, there will be
caveats to the definition of Loss, such as a provision
stating that the definition does not include “the return
or repayment of any fees or commissions charged to
clients.” Unlike D&O policies that cover “Loss,” and
that are eroded by the payment of defense costs to the
extent they fall within the definition of Loss, an E&O
policy often pays defense costs in addition to limits
of liability.
October 2007 | Insurance Coverage Alert
Because insurers may attempt to treat the definition of
Loss as a coverage-limiting provision, a policyholder
should carefully structure any settlement of an
investigation to prevent an insurer from arguing that
the settlement falls outside the definition of Loss.
For example, if a settlement states that the settlement
funds are to pay “fines and penalties,” an insurer
would likely argue that such a payment does not
constitute a covered Loss, as the term “Loss” does not
specifically include fines or penalties. Similarly, if a
settlement is characterized as a payment for restitution
or disgorgement of ill-gotten gains, the insurer may
also contend it is not a covered Loss, even though
those terms do not appear among the matters that do
not constitute Loss.
Common Exclusions
Frequently Asserted By Insurers
There are several exclusions found in D&O/E&O
policies that may be implicated by government
investigations.
Fraud and Improper Personal
Profit Exclusions
Virtually all D&O/E&O policies contain some type of
exclusion for improper personal profit, and fraudulent
or dishonest conduct. For example, some D&O/E&O
policies will not cover a Loss “where it is established
in fact that the Insureds gained any profit, remuneration
or pecuniary advantage to which they were not legally
entitled or committed any fraudulent or criminal
Wrongful Act with actual knowledge of its wrongful
nature or with intent to cause damage.” (emphasis
added). In contrast, some D&O/E&O policies state that
the fraud (and the personal profit) exclusion will apply
only “for any deliberately fraudulent act or omission
or any willful violation of any statute or regulation
committed by such Insured Person, if a judgment
or other final adjudication adverse to such Insured
Person establishes such a deliberately fraudulent act or
omission or willful violation.” (emphasis added).
Known Claims or Circumstances
A D&O/E&O policy may contain a “known Claims or
circumstances exclusion.” Such an exclusion provides
that the insurer “shall not be liable to pay any Loss in
connection with any Claim based upon, directly or
indirectly arising out of, or in any way involving any
Claim and/or circumstances which could give rise to
a Claim, of which any of the Insureds has actual or
constructive knowledge prior to the beginning of the
Policy Period.” Based on this exclusion, an insurer
might seek to deny coverage on the ground that there
was knowledge of the circumstances of the claims prior
to the inception of the D&O/E&O policy.
Severability
A financial institution will also want to determine if
the policy contains a “severability” provision in the
exclusions section of the policy. Such a provision
protects innocent insureds and establishes that, for
purposes of determining whether an exclusion applies,
the Wrongful Act of one insured is not imputed to
other insureds. Many D&O/E&O policies contain
severability for the fraudulent/criminal acts and
personal profit exclusions discussed above. Thus,
even if an insurer could show illicit profit or fraud by
one insured, it could not deny coverage to the other
insureds on that basis alone.
Misrepresentation
Most D&O/E&O policies provide that statements made
in the insurance application and materials supporting
the application are true and are incorporated into the
D&O/E&O policy, and the D&O/E&O policy is issued
in reliance upon such statements.
In several recent high-profile cases such as Enron and
WorldCom, insurers have tried to rescind policies
as to all potential insureds on the ground that the
policyholder misrepresented critical information during
the application process. Because rescission renders the
policy void from its inception, it is a drastic remedy
and the insurer generally bears a heavy burden to
prevail. As a result of the recent high-profile efforts
by carriers to rescind policies, policyholders have
sought severability provisions expressly applicable
to representations made in connection with the
policy application. These provisions make it clear
that misrepresentations, or omissions, made by one
officer in connection with the policy application will
not operate to void the coverage as to other, innocent
officers or directors covered by the policy’s terms and
conditions.
Insurer Consent
Many D&O/E&O policies state that the insured “shall
not admit liability, consent to any judgment, agree to
any settlement or make any settlement offer without
October 2007 | Insurance Coverage Alert
the Insurer’s prior written consent, such consent not
to be unreasonably withheld.” If an insured fails to
obtain the requisite consent, the insurer may not be
liable for any damages or Loss arising therefrom.
Thus, if a financial institution acts to settle without
first seeking its insurer’s consent, the insurer may deny
coverage. Yet, the D&O/E&O policy also states that
such consent is “not to be unreasonably withheld,”
and an insurer may deny consent only if it has a good
reason for doing so.
Similarly, some D&O/E&O policies also require the
insured to obtain the insurer’s consent prior to incurring
“Defense Costs.” Thus, if a financial institution fails
to seek an insurer’s consent to defense costs, or to
the retention of defense counsel in an underlying
action, an insurer may refuse to cover such costs on
the ground that they were incurred in violation of the
policy terms.
Conclusion
This article touches upon some of the insurance
coverage issues financial institutions face as targets
of government investigations by a regulatory agency
or a state Attorney General. Because D&O/E&O
policies vary greatly, financial institution policyholders
will want to review their policies and consult with
experienced insurance counsel to determine whether
the policies afford coverage for the defense of the
investigations and, if necessary, whether settlements
or judgments are potentially covered.
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