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Defeating Phantom Exclusions in D&O and E&O Coverage: Guidance for Policyholders

Overcoming Denials of Coverage Based on Restitution and Disgorgement After U.S. Bank N.A. v. Indian Harbor Ins. Co.

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THURS DAY, JULY 26, 2018

Presenting a live 90‐minute webinar with interactive Q&A

Alexander D. Hardiman, Partner, Pillsbury Winthrop Shaw Pittman, New Y

• rk

Noel Paul, Reed Smith, Chicago

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Defeating Phantom Exclusions in D&O and E&O Coverage: Guidance for Policyholders

Noel Paul npaul@reedsmith.com

Key Policy Terms and Provisions

• Professional Liability/Errors & Omissions Policy

– Provides coverage for professional negligence. – Coverage grant: Insurer agrees to pay on behalf of any

Insured Damages and Claims Expenses … arising out of any Wrongful Act … in rendering or failure to render Professional Services.

– “Wrongful Act”: Any negligent act, error, omission,

misstatement, misleading statement, neglect, or breach of duty by the Insured in providing (or failing to provide) Professional Services.

6

Key Policy Terms and Provisions

• Professional Liability/Errors & Omissions Policy

– Defense provision: Insurer shall have the right and duty

to defend any Claim against the Insured … even if any of the allegations of the Claim are groundless, false or fraudulent. – “Damages”: a monetary judgment, award or settlement, provided that the term Damages shall not include or mean: (1) future profits, restitution, disgorgement of unjust enrichment or profits by an Insured….

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Key Policy Terms and Provisions

• Professional Liability/Errors & Omissions Policy

– “Loss”: Damages, settlements and Costs, Charges and Expenses

which the Insured is legally obligated to pay, but shall not include … matters deemed uninsurable under the law pursuant to which this Policy shall be construed. – Conduct exclusion: Insurer shall not be liable to make any payment in connection with any Claim, brought about or contributed to by: (i) any deliberately dishonest, fraudulent or criminal act or omission by any Insured; or (ii) any personal profit or advantage gained by any Insured to which they were not legally entitled; which is established by: a final judgment, ruling or finding in the underlying civil, criminal, administrative, regulatory or arbitration proceeding.

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Key Policy Terms and Provisions

• Directors & Officers Policy

– Provides coverage for claims against directors and officers and Securities Claims against Company. – Coverage grant: This policy shall pay the Loss of any Company arising from any Securities Claim made against such Company for any Wrongful Act of such Company. – “Wrongful Act”: Any actual or alleged breach of duty, neglect, error, misstatement, misleading statement,

• mission or act with respect to the Company, any actual or

alleged breach of duty, neglect, error, misstatement, misleading statement, omission or act by such Company, but solely in regard to a Securities Claim.

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Key Policy Terms and Provisions

• Directors & Officers Policy

– “Loss”: Damages, settlements, judgment, and Defense Costs; however, “Loss” shall not include: (1) civil or criminal fines or penalties; (2) taxes; (3) punitive or exemplary damages … (7) matters which may be deemed uninsurable under the law pursuant to which this policy shall be construed. – “Most favored nation” provision: “Enforceability of this paragraph shall be governed by such applicable law that most favors coverage.”

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Key Policy Terms and Provisions

• Directors & Officers Policy

– Conduct exclusion:The Insurer shall not be liable to make any payment for Loss in connection with any Claim made against an Insured arising out of: remuneration, profit or other advantage to which the Insured was not legally entitled; or deliberate criminal

• r deliberate fraudulent act by the Insured; if

established by any final, non‐appealable adjudication in any action or proceeding other than an action or proceeding initiated by the Insurer to determine coverage under the policy.

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Rules of Policy Interpretation

• Coverage grant construed broadly and

exclusions construed narrowly in favor of coverage.

• Ambiguities typically construed against

insurance carrier.

• Burden on insurer to prove limitation on

coverage.

• Policy interpreted as a whole to give meaning

and effect to each provision.

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Defeating Phantom Exclusions in D&O and E&O Coverage: Guidance for Policyholders

Strafford Presentation July 26, 2018 Alexander D. Hardiman

212.858.1064 Alexander.Hardiman@pillsburylaw.com

Level 3 Communications

• Level 3 Commc'ns, Inc. v. Fed. Ins. Co., 272

F.3d 908 (7th Cir. 2001)

• Judge Richard R. Posner:

“Modern judicial opinions tend to be too long, and we shall try to be

• brief. We shall even forgo the usual prefatory statement of facts,

which would disclose an utterly routine, though very large, illegal drug

• peration.” U.S. v. Herrera‐Medina (1988).
• A two page opinion cited 747 times.

14

Level 3 Was Not The First

• Level 3 was not the first to consider the insurability
• f “restitution” and “disgorgement of ill‐gotten

gains”

• Various courts had already held that restitution or

disgorgement are not covered under insurance policies

• But Level 3 was the most influential as it brought

together the broad interpretive principles used as a basis to bar restitutionary payments

15

PRE‐LEVEL 3 CASES

• Nortex Oil & Gas Corp. v. Harbor Insurance Co.,

456 S.W.2d 489 (Tex. Civ. App. 1970).

• Town of Brookhaven v. CNA Insurance Cos., 1988

WL 23555 (E.D.N.Y. Feb. 24, 1988).

• Bank of the West v. Superior Court, 833 P.2d 545

(Cal. 1992).

16

Level 3 When a “Loss” isn’t a “Loss”

• Underlying securities fraud suit in which former

shareholders of acquired corporation sought to recover monetary value of shares sold to Level 3

• District court ruled that an $11.8MM settlement

was a covered “Loss” under Level 3’s D&O policy

• 7th Circuit reverses, no “Loss” here, and upends

D&O coverage for securities suits

17

Level 3 Securities Fraud Cases are Essentially Uninsurable

• “The interpretive principle for which Federal contends‐

that a “loss” within the meaning of an insurance contract does not include the restoration of an ill‐gotten gain‐is clearly right.”

• "They were seeking the difference between the value
• f the stock at the time of trial and the price they had

received for the stock from Level 3. That is standard damages relief in a securities‐fraud case. But it is restitutionary in character. It seeks to divest the defendant of the present value of the property

• btained by fraud, minus the cost to the defendant of
• btaining the property.”

18

Level 3 Thieves Don’t Get Insurance

"An insured incurs no loss within the meaning of the insurance contract by being compelled to return property that it had stolen, even if a more polite word than “stolen” is used to characterize the claim for the property’s return.”

19

Level 3 And a Settlement Ain’t Gonna Help Ya!

“It would mean, as Level 3’s lawyer confirmed at argument, that if Level 3, seeing the handwriting on the wall, had agreed to pay the plaintiffs in the fraud suit all they were asking for (a very large amount‐almost $70 million), which they surely would not have done had there been no evidence of fraud (no rational defendant settles a nuisance suit for the full amount demanded in the complaint, unless the amount is trivial), Federal would still be obligated to reimburse Level 3 for that

• amount. And that would enable Level 3 to retain the profit it

had made from a fraud.”

20

Post‐Level 3 Posner’s Right! No Insurance for Thieves

• Conseco, Inc. v. National Union Fire Insurance Co. 2002 WL

31961447 (Ind. Ct. App. Dec. 31, 2002):

• “It is axiomatic that insurance cannot be used to pay an

insured for amounts an insured wrongfully acquires and is forced to return, or to pay the corporate obligations of an insured.”

• Vigilant Insurance Co. v. Credit Suisse First Boston Corp. 782

N.Y.S.2d 19 (N.Y. App. Div. 2004):

• “The risk of being directed to return improperly acquired

funds is not insurable. Restitution of ill‐gotten funds does not constitute ‘damages’ or a ‘loss’ as those terms are used in insurance policies.”

21

• Cohen v. Lovitt & Touche, Inc. 308 P.3d 1196 (Ariz. Ct. App. 2013):
• $16 million settlement in a failure to provide employees with tips from

service charge

• This is Arizona and our state motto is “Ditat Deus” – God Enriches:
• Level 3’ s approach “forecloses consideration of variation in contractual

language,” which might mitigate or even eliminate public policy concerns because Level 3 and its progeny focus solely on the nature of the claim rather than the conduct of the insured.

• Policy forbidding coverage for restitutionary payments has never been expressed

in any Arizona legislation or judicial decisions and “parties to an insurance contract are fully capable of drafting language that prohibits coverage when an insured has intentionally or recklessly acquired property in a wrongful fashion.”

Post‐Level 3 Hold on, It’s Not that Simple

22

Post‐ Level 3 The Turning of the Tide

• When is “disgorgement” or “restitution” actually

damages?

• Do labels matter?
• Does this state have a public policy?

23

US Bank v. Indian Harbor

• U.S. Bank Nat. Assoc. v. Indian Harbor Ins. Co., 68

F.Supp.3d 1044 (D. Minn. Dec. 16, 2014)

• Background:

– Three class‐action suits against US Bank alleging it unlawfully engaged in high‐to‐low posting that resulted in more and higher overdraft fees. – Suits alleged claims of breach of contract and unjust enrichment and sought remedies of damages and return of overdraft fees. – US Bank settled the suits for $55 million with no admission of liability.

24

US Bank v. Indian Harbor

• Background:

– US Bank gave notice of suits to professional liability carriers Indian Harbor and ACE. – The Insurers consented to settlement of the suits but denied coverage for the settlements and US Bank’s defense costs. – Insurers argued there was no coverage because of exception to definition of “loss,” for “[m]atters which are uninsurable under the law pursuant to which this Policy is construed.” – US Bank sued in Minnesota and Court granted US Bank summary judgment on coverage for settlement and defense costs.

25

US Bank v. Indian Harbor

• Court’s Analysis:

– Court assumed that restitution is uninsurable under Delaware law. Court stated however: “[t]he crux of this dispute is not whether restitution is insurable, but whether the settlement constitutes restitution.” The Court concluded that it didn’t. – Court pointed to policies’ “Ill‐Gotten Gains” provision which excluded from coverage “any payment for Loss in connection with any Claim made against [US Bank] … brought about or contributed n fact by any … profit or remuneration gained by [US Bank] to which [it] is not legally entitled … as determined by a final adjudication in the underlying action.” – Reading the policy as a whole, Court determined that interpreting “Uninsurable” provision to preclude coverage for a settlement resolving claims for restitution would nullify the “Ill‐Gotten Gains” provision and its requirement for a final adjudication.

26

US Bank v. Indian Harbor

• Court’s Analysis:

– Unlike other courts, the US Bank Court rejected Insurer’s invitation to presume that the settlement constitutes restitution merely because it resolved claims alleging ill‐gotten gains. – The Court distinguished the holding from Level 3 on the basis that it did not involve policies that included a “final‐adjudication requirement.” – Moreover, the Level 3 court’s argument that coverage would allow companies to merely settle claims against them to secure coverage is countered by insurer’s ability to withhold consent to such settlements – which the insurers here failed to do – or condition consent on stipulation that settlement payment is restitution.

27

Post‐US Bank Cases

• Gallup, Inc. v. Greenwich Ins. Co., No. N14C‐02‐136,

2015 WL 1201518 (Del. Super. Ct. Feb. 25, 2015)

– Gallup was sued in a qui tam action alleging violation of the False Claims Act by charging the government more than it agreed to pay. – Insurer that issued Management Liability policy denied coverage for settlement of FCA claim, partially on grounds that it was uninsurable disgorgement. – Court found that settlements were expressly covered “loss,” because policy’s definition of “loss” includes “settlements” and Insurer could have drafted “loss” definition to not include settlements.

28

Post‐US Bank Cases

• Gallup, Inc. v. Greenwich Ins. Co., No. N14C‐02‐

136, 2015 WL 1201518 (Del. Super. Ct. Feb. 25, 2015)

– Relying on US Bank, court construed “Uninsurable” provision in context of policy’s “Ill‐Gotten Gains” exclusion, which required final adjudication that Insured was not entitled to money. – The “Ill‐Gotten Gains” provision showed that the Insurer agreed “reimbursement for restitution would

• nly be precluded upon a final adjudication that the

money Plaintiff received was actually restitution.”

29

Post‐US Bank Cases

• Burks v. XL Specialty Ins. Co., 534 S.W.3d 458 (Tex. App.

2015)

– Bankruptcy trustee brought fraudulent transfer claim for money and stock against company’s former CFO, and CFO settled claim without admission of liability. – XL denied coverage under D&O policy, citing definition of “Loss,” which included the “Uninsurable” provision. – While assuming that disgorgement was not insurable under Texas law, the Court held that XL was obligated to provide coverage:

• No evidence that the settlement was for disgorgement;
• No Texas law prohibiting coverage for a settlement of a claim seeking

disgorgement.

– Relying on US Bank, Court concluded XL had no basis to deny coverage.

30

Post‐US Bank Cases

• TIAA‐CREF v. Illinois National Ins. Co., No. N14C‐

05‐178, 2016 WL 6534271 (Del. Super. Ct. 2016)

– Three class‐action suits alleged company improperly failed to credit accounts of customers with investment gains while transfer or withdrawal requests were being processed. – Company settled suits without any admission of liability and sought coverage from professional liability carriers. – Applying New York law, Court held amounts TIAA‐ CREF paid in settlement did not represent uninsurable disgorgement.

31

Post‐US Bank Cases

• TIAA‐CREF v. Illinois National Ins. Co., No.

N14C‐05‐178, 2016 WL 6534271 (Del. Super.

• Ct. 2016)
• Court distinguished from three New York cases cited by

insurers, which involved claims brought by government regulators and all involved “conclusive links between the insured’s misconduct and the payment of monies,” where as TIAA‐CREF’s settlement involved “no conclusive link between the settlements … and wrongdoing … that would render the settlement[s] … uninsurable disgorgement.”

32

Post‐US Bank Cases

• Philadelphia Indem. Ins. Co. v. Sabal Ins. Group, Inc., No. 16‐

62168, 2017 WL 4310700 (S.D. Fla. Sept. 28, 2017) (on appeal)

– Insured was indicted with five counts of grand theft related to alleged overcharging of Miami‐Dade Aviation Department. – Insured entered into settlement with State of Florida that included payment of a “settlement sum,” donation” to a victims’ fund and “costs of investigation,” but no admission of liability. – Insurer denied coverage for settlement on the grounds that it represented disgorgement of ill‐gotten gains and was uncovered “loss.” – Policy included “Uninsured” provision and “Ill‐Gotten Gains” exclusion.

33

Post‐US Bank Cases

• Philadelphia Indem. Ins. Co. v. Sabal Ins. Group,

Inc., No. 16‐62168, 2017 WL 4310700 (S.D. Fla.

• Sept. 28, 2017) (on appeal)

– Insured relied on US Bank and Gallup in arguing policy did not exclude settlement for ill‐gotten gains. – The Court disagreed with US Bank and Gallup, reasoning that disgorgement is uninsurable “loss,” and the “Ill‐Gotten Gains” exclusion cannot “create” coverage where none exists. – Court’s analysis ignores judicial canon that policy must be interpreted as a whole – definition of “loss” cannot be read in isolation.

34

A Word About JP Morgan Securities

• J.P. Morgan Securities Inc. v. Vigilant Ins. Co.,

21 N.Y.3d 324 (N.Y. 2013)

– Insured had viable D&O claim for amounts SEC required it to pay as “disgorgement,” because amounts represented profits made by customers, not the insured. – On remand, trial court struck insurers’ “uninsurability” defense because disgorgement payment represented gains of third parties.

35

Negotiate the Best Policy Terms

• Remove the “restitution” or “disgorgement”

exceptions to definition of “Loss”

• Obtain an explicit provision that losses for

violations of Sections 11, 12 and 15 of the Securities Act of 1933 will not be deemed “uninsurable” or “restitution” or “disgorgement”

36

Negotiating the Best Policy Terms

• Obtain a “most favored nation” clause with respect

to “uninsurability”

• Consider what law will apply to the policy and a

choice of law clause

• Ask the insurer in writing whether it will consider

the remedies under identified statutory areas of risk as uninsurable, restitution or disgorgement

37

Negotiating the Best Policy Terms

• Obtain a “most favored nation” clause with respect

to “uninsurability”

• Consider what law will apply to the policy and a

choice of law clause

• Ask the insurer in writing whether it will consider

the remedies under identified statutory areas of risk as uninsurable, restitution or disgorgement

38

Alexander Hardiman Partner/Insurance Recovery

212.858.1064 Alexander.Hardiman@pillsburylaw.com