Insurance Coverage Alert
March 2007
www.klgates.com
Authors:
Matthew L. Jacobs
1
+1.202.778.9393
matt.jacobs@klgates.com
David T. Case1
+1.202.778.9084
david.case@klgates.com
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Insurance Coverage for Subprime Lending
Lawsuits and Investigations
Subprime mortgage lenders and related entities that have become the targets of lawsuits and
investigations may be able to access valuable insurance coverage to defray their defense
costs and, if necessary, satisfy settlements or judgments resulting from such matters. Several
securities actions already have been filed against subprime lenders. One lead plaintiffs’ lawyer
has stated that he intends to file securities actions against at least four subprime lenders who
are alleged to have issued financial statements failing to disclose that loan defaults were
increasing and that their earnings were going to suffer allegedly as a result of having to
increase bad debt reserves.2 Plaintiffs’ lawyers may also file suits against the auditors that
signed off on the subprime lenders’ financial statements. In addition, investment banks that
packaged subprime mortgage-backed securities sold in the secondary market and the stock
brokers that marketed them could become the subject of investor actions.3 Finally, mortgage
brokers involved in placing the loans may face lawsuits alleging that they had knowledge
of allegedly misleading financial filings and mismanagement in connection with subprime
business operations.
When faced with a lawsuit or investigation into their business operations, subprime lenders,
auditors, investment banks and mortgage brokers should examine their insurance coverage
program to determine the coverage available to respond to those matters.4 By way of example,
for subprime lenders and related financial institutions facing lawsuits or 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”). In addition, Comprehensive General Liability (“CGL”) policies should respond to
claims of property damage, bodily injury, personal injury, and advertising injury.
Typically, the “insured” under an E&O policy includes a professional business entity such
as a banking institution, a mortgage banking service provider, or an auditor as well as the
individuals who provide professional services on behalf of that business entity.
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. 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 investigation is related to business operations and the employees associated
with those operations, which is likely to be the basis of lawsuits stemming from subprime
lending operations, it is likely that E&O coverage may afford coverage for defense costs and
5
indemnity, or the damages associated with such matters.
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.
Insurance Coverage Alert
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.
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.
A lawsuit will always constitute a “Claim” under a
commercially available D&O/E&O policy. 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 selfregulatory organization (SRO), against an Insured for a
Wrongful Act, including any appeal therefrom.
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 investigation. 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. This is significant for
subprime lending suits and investigations because
those matters appear more likely to trigger coverage
under E&O policies. 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,” which allows the
insured to extend the time during which a “Claim”
can be reported to the insurer and covered under the
policy.
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
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Insurance Coverage Alert
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.
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 are not listed 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 lawsuits or
government investigations arising from subprime
lending practices.
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 subprime lender or related entity also will 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 high-profile cases such as Enron and
WorldCom, insurers 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 high-profile efforts by carriers to
rescind policies based on the submission of allegedly
misleading financial statements along with the policy
application, and because some of the recent subprime
lending lawsuits allege that lenders also generated
inaccurate financial statements, policyholders have
March 2007 | 3
Insurance Coverage Alert
relied upon severability provisions expressly applicable
to representations made in connection with the policy
application to address the carriers’ efforts. 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 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 subprime lender 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 Alert touches upon some of the insurance coverage
issues subprime lenders and related entities may face
after they become the target of lawsuits or government
investigations by unhappy investors, a regulatory
agency or a state Attorney General. Of course, because
D&O/E&O policies vary greatly, all policyholders
will want to review their particular policies and
perhaps 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.
Endnotes
1
Matthew L. Jacobs and David T. Case are partners in the D.C.
office of Kirkpatrick & Lockhart Preston Gates Ellis LLP, where
they have a national practice advising and litigating on behalf
of corporate policyholders seeking coverage for matters arising
under directors’ and officers’, errors and omissions, commercial
and comprehensive general liability, umbrella, excess, first-party,
professional and other forms of insurance coverage. The views
expressed in this Alert are not necessarily those of K&L Gates
nor its clients. This Alert is for informational purposes only and
does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts
or circumstances without first consulting with a lawyer.
2 Business Insurance, “Mortgage Woes Spark D&O Suits,”
March 19, 2007.
3
Id.
4 For further information on suggested steps and procedures
for responding to governmental investigations of fair lending and
consumer protection issues, please see the K&L Gates Mortgage
Banking and Consumer Credit Alert titled “Fair Lending:
What To Do When The Government Comes Knocking” by
Paul F. Hancock and Melanie H. Brody. March 2007.
5 For purposes of this article, the issues relevant to the
availability of coverage for governmental investigations are, for
the most part, identical for both D&O and E&O policies, and will
be referred to as if the policyholder had been issued a combined
D&O/E&O policy.
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