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Coverage For Restitutionary Damages

By Dan A. Bailey

Two recent court decisions addressed the issue of whether a D&O insurance policy covers certain types of restitutionary damages which are not expressly excluded by the policy. In both cases, the court ruled no such coverage existed, based on the fundamental premise that insurance should not cover the return of ill-gotten gain. To hold otherwise, the courts would be allowing the defendant to retain the ill-gotten gain, which obviously is inconsistent with basic notions of fairness and public policy.

Although this fundamental premise is inescapably proper and correct, it can lead to some surprising results and difficult coverage issues in the context of D&O insurance, as explained below.

Recent Decisions

The two recent decisions are briefly summarized below.

Level 3 Communications, Inc. v. Federal Insurance Co., 272 F.3d 908 (7th Cir. 2001).

The plaintiffs in the underlying claim were shareholders of a company acquired by Level 3. Plaintiffs alleged that they sold their shares in the company to Level 3 based on fraudulent representations and omissions by Level 3 and its officers, thereby causing the plaintiffs to sell their shares at too low of price. Thus, plaintiffs sought to recover from Level 3 and its officer defendants the true monetary value of the shares the plaintiffs sold to Level 3. In the middle of trial, the case settled for $12 million.

The D&O insurers denied coverage arguing (among other things) that the situation is essentially the same as if Level 3 had stolen money from the plaintiffs, agreed to return the stolen money, and then requested the insurance company pay to plaintiffs the amount of the stolen money. In a November 26, 2001 decision, the Seventh Circuit Federal Court of Appeals ruled that the D&O insurance policy did not cover the settlement:

“[A]‘loss’ within the meaning of an insurance contract does not include the restoration of an ill-gotten gain.... 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.” 272 F.3d at 910, 911.

The Court’s analysis was limited to coverage for the settlement amount, and did not limit coverage for defense costs.

Conseco, Inc. v. National Union Fire Insurance Company of Pittsburgh, PA, et al., Cause No. 49D130202CP000348, Marion Circuit Court, Marion County, Indiana (December 31, 2002).

The underlying claim was a securities class action against Conseco and 15 of its directors and officers. The class action alleged that the defendants made materially false and misleading statements which resulted in (i) the market price for Conseco’s common stock being artificially inflated during the class period, and (ii) Conseco selling certain debt securities in a public offering at an artificially inflated price. Plaintiffs alleged violations of Section 10(b) of the Securities Exchange Act of 1934 and Sections 11 and 12 of the Securities Act of 1933.

The class action lawsuit was settled for $120 million and the defendants sought coverage for the settlement amount under its D&O insurance program. Although some insurers in the program ultimately recognized coverage and paid their limits, several excess insurers denied coverage on the basis that the Sections 11 and 12 portion of the settlement does not constitute “loss” under the D&O policy. The remaining portion of the settlement attributable to the Section 10(b) claims, plus defense costs, did not exceed those excess insurers’ attachment point. Thus, those excess insurers argued that there was no covered loss in their layer of coverage.

Relying heavily on the Level 3 analysis, the Court ruled that the Sections 11 and 12 portion of the settlement (i.e., the portion of the settlement attributable to misrepresentations in Conseco’s securities offering) was not covered loss under the D&O policies, but instead constituted the restitution to plaintiffs of the inflated sale price of the securities sold by Conseco in the public offering. In other words, Conseco received more money than it should have in the securities offering because of its misrepresentations. Thus, the settlement of the Sections 11 and 12 claims constituted a return of “ill-gotten gain” which cannot be considered “loss” under the excess D&O insurance policies.

This conclusion was not based upon the unique facts of that case, but appears to apply to any settlement or judgment by the issuer under Sections 11 or 12 of the Securities Act of 1933 since the measure of damages under those sections is rescissionary as a matter of law, according to the Court.

Issues Raised By Decisions

The following summarizes some of the more difficult or significant issues raised by these two decisions:

1. Entity Coverage. The decision effectively eliminates entity coverage for settlements or judgments in claims under Sections 11 and 12 of the Securities Act of 1933. Although entity coverage for open-market securities claims under Section 10(b) is unaffected by the decisions, there will be a significant reduction in the scope of entity coverage if the decisions are followed by other courts. This development, when coupled with heightened concerns about entity coverage in a bankruptcy situation, may persuade many companies to delete entity coverage from their D&O insurance policies based on a cost/benefit analysis.

2. D&O Coverage. The Level 3 decision does not distinguish its analysis between coverage for the company and coverage for the defendant directors and officers. The Conseco decision appears to limit its restitutionary damage analysis to only coverage for the company, which conceptually should be the correct analysis in most cases. Directors and officers typically do not realize personal gain from the company’s sale of securities at an artificially inflated price or the company’s purchase of securities at an artificially depressed price. Thus, a settlement or judgment payment on behalf of the defendant directors or officers in such a claim should not constitute a return of ill-gotten gain realized by the defendant directors and officers, and therefore should not be excluded from coverage on public policy grounds. Whether future decisions which follow these cases will recognize this distinction is yet to be seen.

Assuming such a distinction is made, there will need to be an allocation of the Section 11 or 12 settlement between the company and director/officer defendants, even if entity coverage exists in the policy. Arguably, a pre-determined allocation provision in the policy would not be controlling for such an allocation, since such a provision does not purport to define the true amount paid on behalf of the company. The public policy concerns underlying the Level 3 and Conseco decisions would seem to indicate that an allocation based on the unique facts of the case, rather than a predetermined allocation, would be necessary.

3. Required Proof. In the Level 3 case, the Company argued that it should not lose coverage for the settlement based only on unsubstantiated allegations. The Court acknowledged this argument, but refrained from deciding the issue “since we can find no guidance on the point from cases or other materials.” Instead, the Court based its finding of no coverage on the fact that Level 3 settled the claims “for the not inconsiderable amount of $12 million” and that such a large settlement did not reflect merely the anticipated future defense costs since the settlement occurred after the trial had begun. In other words, the Court viewed the size of the settlement as a tacit acknowledgment that plaintiffs’ claims had some merit. The Conseco decision did not address this issue, apparently finding the inquiry unnecessary.

It is thus unresolved today whether the insurer must present some type of “in fact” showing that the insured defendant received an ill-gotten gain in order for this public policy exclusion to apply, and if such a showing is required, what is sufficient evidence. Is the size of the settlement controlling, and if so, how large must the settlement be? Must the insurer in essence re-try the underlying case to determine if the defendants actually received ill-gotten gain?

4. Type of Damages. As these new decisions are applied to other situations, an issue will likely arise as to what types of damages or loss does this public policy limitation apply? For example, is the forfeiture of certain executive compensation under the Sarbanes Oxley Act tantamount to the return of ill-gotten gain when the initial payment of the compensation was proper but subsequent events (e.g., restatement of financial statements) triggered the forfeiture obligation? If a Section 10(b) open-market securities class action is brought against an officer and alleges that the officer artificially inflated the company’s stock price so that the officer could sell shares at the inflated price, is at least a portion of a settlement payment to class members who purchased in the open market a return of ill-gotten gain by the officer? Undoubtedly, there will be much debate in the future regarding the type of damages that are subject to this public policy analysis.

5. Policy Language. These new decisions impact the D&O insurance policy’s terms and conditions in several respects. First, this coverage limitation probably cannot be “fixed” or eliminated with new policy language. The limitation is based on public policy principles that transcend or supercede any inconsistent policy language.

Second, these decisions reduce the benefit associated with applying the policy’s “illegal personal profit, advantage or remuneration” exclusion to only Insuring Clause A (as some policies have done in the past). Even if that exclusion does not expressly apply to Insuring Clause B, no coverage will likely apply under Insuring Clause B for such loss based upon the Level 3 public policy limitation on coverage.

Third, partly in response to these decisions and partly in response to the forfeiture provisions in the Sarbanes Oxley Act of 2002, several D&O insurance policies now include an express exclusion (usually in the definition of Loss) for restitutionary damages or forfeitures. A sample provision is as follows:

Loss does not include...any amount that represents or is substantially equivalent to disgorgement, restitution or rescissionary damages, or forfeiture of any profits or remuneration.

Such language attempts to recognize expressly in the insurance policy this public policy limitation so that Insureds will not be surprised to learn in the midst of a claim of this potentially important lack of coverage. By including this exclusion in the definition of Loss, it should not apply to defense costs or other types of loss in the claim. Like many new policy provisions, it is likely this language will be refined over time in light of subsequent court decisions and claims experiences.

ABOUT THE AUTHOR

This material is provided by and reproduced with permission of Dan A. Bailey. Mr. Bailey is a member of the Columbus, Ohio, law firm of Arter & Hadden LLP. Mr. Bailey specializes in D&O liability insurance, corporate and securities law. He is a frequent lecturer and has authored and co-authored several books dealing with D&O liability issues.

riskVue | The webzine for risk management profesionals
June 2003