Costs Relating to Regulatory Investigations, Derivative Lawsuits ...

Financial Fraud
Law Report
VOLUME 3 NUMBER 9 OCTOBER 2011
HEADNOTE: THINKING ABOUT FINANCIAL FRAUD
Steven A. Meyerowitz 781
PLEADING RICO CLAIMS AGAINST “FLY-BY-NIGHT” NO-FAULT FRAUD RINGS
Max Gershenoff 783
FALSE CLAIMS ACT INVESTIGATIONS: TIME FOR A NEW APPROACH?
John T. Bentivoglio, Jennifer L. Bragg, Michael K. Loucks, and Gregory M. Luce 801
DO FCPA REMEDIES FOLLOW FCPA WRONGS? “DISGORGEMENT” IN INTERNAL
CONTROLS AND BOOKS AND RECORDS CASES
Paul R. Berger, Steven S. Michaels, and Amanda M. Ulrich 812
COSTS RELATING TO REGULATORY INVESTIGATIONS, DERIVATIVE LAWSUITS, AND
INDEPENDENT CONSULTANT’S INVESTIGATIONS ARE COVERED UNDER CONTRACTS
FOR DIRECTORS’ AND OFFICERS’ LIABILITY INSURANCE
Michael S. Levine and Erika L. Smith 820
FIRST TRIAL IN “CATCH 22” FOREIGN CORRUPT PRACTICES ACT PROSECUTION
ENDS IN HUNG JURY ON ALL COUNTS
Iris E. Bennett, Jessie K. Liu, Sean J. Hartigan, and Julia K. Martinez 826
SEC’S FIRST USE OF A NON-PROSECUTION AGREEMENT SHOWS POTENTIAL
BENEFITS FOR RESPONDENTS BUT ALSO DEMONSTRATES POTENTIAL PITFALLS
Bruce A. Hiler and Thomas A. Kuczajda 831
THE DODD-FRANK ACT’S NEW WHISTLEBLOWER AND BOUNTY PROVISIONS
Joseph P. Sirbak, II 840
THE U.K. BRIBERY ACT TODAY
James Maton and Antonio Suarez-Martinez 846
THE U.K. PROCEEDS OF CRIME ACT AND THE SFO’S LATEST BRIBERY-RELATED
SETTLEMENT
Karolos Seeger and Matthew Getz 863
DC AND SEVENTH CIRCUITS SPLIT FROM SECOND CIRCUIT: ALLOW FOR CORPORATE
LIABILITY UNDER ALIEN TORT STATUTE
Sander Bak 871

EDITOR-IN-CHIEF
Steven A. Meyerowitz
President, Meyerowitz Communications Inc.
BOARD OF EDITORS
Frank W. Abagnale
Author, Lecturer, and Consultant
Abagnale and Associates
Stephen L. Ascher
Partner
Jenner & Block LLP
Thomas C. Bogle
Partner
Dechert LLP
David J. Cook
Partner
Cook Collection Attorneys
Robert E. Eggmann
Partner
Lathrop & Gage LLP
Jeffrey T. Harfenist
Managing Director,
Disputes & Investigations
Navigant Consulting (PI) LLC
James M. Keneally
Partner
Kelley Drye & Warren LLP
Frank C. Razzano
Partner
Pepper Hamilton LLP
Bethany N. Schols
Member of the Firm
Dykema Gossett PLLC
Bruce E. Yannett
Partner
Debevoise & Plimpton
LLP
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Costs Relating to Regulatory
Investigations, Derivative Lawsuits, and
Independent Consultant’s Investigations
Are Covered Under Contracts for
Directors’ and Officers’ Liability
Insurance
MICHAEL S. LEVINE AND ERIKA L. SMITH
The authors discuss a United States Court of Appeals for the Second Circuit
decision holding that a policyholder was entitled to coverage under
a directors’ and officers’ liability insurance contract for costs associated
with financial regulators’ investigations.
In MBIA Inc. v. Fed. Ins. Co. 1 the U.S. Court of Appeals for the Second
Circuit held that a policyholder was entitled to coverage under
directors’ and officers’ liability insurance contracts for costs associated
with financial regulators’ investigations, including costs associated
with the investigation of a derivative shareholder litigation and the cost
of an independent consultant’s investigation pursuant to a settlement with
government regulators.
Michael S. Levine, counsel with Hunton & Williams LLP, represents and advises
policyholders and other commercial clients in complex insurance coverage and
business disputes. Erika L. Smith is an associate at the firm.
820
Published by A.S. Pratt in the October 2011 issue of the Financial Fraud Law Report
Copyright © 2011 THOMPSON MEDIA GROUP LLC. 1-800-572-2797.

CONTRACTS FOR DIRECTORS’ AND OFFICERS’ LIABILITY INSURANCE
BACKGROUND
MBIA, Inc. (“MBIA” or the “Policyholder”), a Connecticut bond insurer,
purchased directors’ and officers’ insurance policies from Federal
Insurance Co. (“Federal”) and ACE American Insurance Co. (“Ace”) (collectively
the “Insurers”). The policies provided coverage for, among other
things, “Securities Claims” and “Securities Defense Costs.” Securities
Claims were defined to be “a formal or informal administrative or regulatory
proceeding or inquiry commenced by the filing of a notice of charges,
formal or informal investigative order or similar document.” Securities
Defense Costs were defined as “costs incurred in defending or investigating
Securities Claims.”
On March 9, 2001, the Securities and Exchange Commission (“SEC”)
issued a formal order of investigation of MBIA. In 2004, as part of the
investigation, the SEC issued several subpoenas to MBIA, seeking documents
concerning its compliance with securities laws, financial recordkeeping
and financial reporting. The New York attorney general (“NYAG”)
followed suit and issued a subpoena to MBIA in connection with a separate,
but similar, investigation. Following the initial phases of the SEC and
NYAG investigations, MBIA was targeted for three specific transactions:
the AHERF transaction, the Capital Asset transaction, and the US Airways
transaction.
In May 2005, MBIA informed its Insurers that it was the subject of a
regulatory investigation by providing the SEC and NYAG subpoenas to
the Insurers. The Insurers did not view the subpoenas as sufficient to trigger
coverage; however, they accepted the subpoenas as notice of a potential
claim under the policies. In the summer of 2005, when the SEC and the
NYAG considered issuing additional subpoenas, MBIA negotiated voluntary
compliance in lieu of the subpoenas to avoid further adverse publicity.
The SEC and the NYAG accepted voluntary compliance concerning the
Capital Asset and US Airways transactions.
In August 2005, federal and state regulators advised MBIA that they
intended to take action against MBIA for securities law violations. MBIA
sought consent from its Insurers to settle with the regulators. The Insurers
contended the settlement was not covered by the policy, but, nevertheless,
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FINANCIAL FRAUD LAW REPORT
agreed to waive lack of written consent to settlement as a defense to coverage.
Accordingly, MBIA signed a preliminary offer of settlement with
the SEC and the NYAG, which included, among other terms, that MBIA
agreed to hire an independent consultant to review the Capital Asset and
US Airways transactions, both of which were at issue in the investigation
and alleged violations.
As a result of the investigations, MBIA’s shareholders brought two derivative
suits alleging financial wrongdoing by MBIA. In accordance with
Connecticut law, MBIA was required to set up a committee of independent
directors (the “Demand Investigation Committee” or “DIC”) and a special
litigation committee (the “SLC”) to determine whether maintaining the
suits was in the best interests of MBIA. The SLC ultimately determined
that the lawsuits should be dismissed, but not before MBIA had incurred
substantial costs.
MBIA agreed to pay $50 million in civil penalties for the AHERF
transaction, and MBIA was exonerated of any wrongdoing for the Capital
Asset and US Airways transactions. The Insurers, however, agreed to
cover only $6.4 million in costs, refusing to cover costs associated with the
NYAG investigation, the Capital Asset investigation or the US Airways
investigations.
As a result, MBIA filed a lawsuit in the Southern District of New York
to compel the Insurers to cover the costs of all three investigations. After
review, the district court granted summary judgment in favor of MBIA
regarding coverage for costs associated with all three investigations, as
well as the costs incurred by the SLC. The district court awarded summary
judgment to the Insurers with respect to coverage for costs associated with
the independent consultant’s investigation. Both parties appealed.
The Insurers argued that the district court erred in two ways. First, the
Insurers argued that the NYAG investigation, the Capital Asset investigation
and the US Airways investigations were not “Securities Claims,” as
defined by the policies. In support, the Insurers contended that the NYAG
subpoena did not constitute a formal order, and the caption on the SEC order
served to limit the scope of the investigation to a certain class of transactions,
not to include the Capital Asset or US Airways investigations. The
Insurers also argued that the Capital Asset and US Airways investigations
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CONTRACTS FOR DIRECTORS’ AND OFFICERS’ LIABILITY INSURANCE
were not Securities Claims because MBIA voluntarily complied with the
SEC’s document requests rather than producing them through the subpoena
process and because the SEC official making the requests was not
named on the initial SEC order.
Second, the Insurers argued that the district court erred because costs
incurred by the SLC either were not covered, since the SLC was not an
“Insured Person,” or they were subject to a $200,000 policy sublimit.
MBIA argued that the district court erred in denying coverage for the
costs of the independent consultant.
HOLDING
Upon review, the Second Circuit affirmed the district court’s ruling for
MBIA concerning the costs associated with the three investigations and
the costs incurred by the SLC. But, the Second Circuit reversed the district
court concerning the independent consultant’s costs and held that MBIA is
also entitled to coverage for those costs.
According to the Second Circuit, the NYAG’s subpoena came within
the definition of a “Securities Claim” because the subpoena was “at least a
similar document” to a “formal or informal investigative order” that commenced
a regulatory proceeding. Thus, because the subpoena amounted to
a Securities Claim, the investigatory costs associated with that subpoena
were “Securities Losses” as defined in the policy.
The court also held that the SEC’s investigations of the Capital Asset
and US Airways transactions were covered “Securities Losses.” The court
looked to the nature and scope of the SEC’s formal order, and not to the
caption or persons named on the subpoena, as the Insurers had argued, to
define the scope of the investigation. The court stated that the investigation
need not be pursued by only individuals named on the formal order. The
court also refused to attach significance to MBIA’s voluntarily compliance
with the regulators’ document requests, explaining that a company may
take steps to mitigate public relations damage and exposure without jeopardizing
coverage that otherwise would be reasonably expected to apply.
Next, the Second Circuit held that MBIA could recover the costs associated
with the SLC, thereby rejecting the Insurers’ argument that the
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FINANCIAL FRAUD LAW REPORT
SLC was not an “Insured Person” under the policy. The court reasoned
that the SLC’s independence was an “independence of judgment,” rather
than a new source of authority. The court also held that the Insurers failed
to prove that the SLC costs fell within the $200,000 policy sublimit for
shareholder demand investigations. The court reasoned that the $200,000
sublimit would apply only to pre-litigation demand costs and not to litigation-related
costs of the SLC.
Finally, the Second Circuit determined whether the costs associated with
the independent consultant were covered under the policies. The district
court had found that MBIA could not recover the independent consultant
costs because MBIA breached the policies’ “right to associate” provision.
But, the Second Circuit disagreed, finding that MBIA fulfilled its obligations
under the right to associate clause when it provided notice to the Insurers of
the claims involved in the settlement discussions. The court explained that
“where the insured gives the insurers an invitation to associate with adequate
information about the claim under consideration for settlement, the insured
has done what is required under this clause.” This is the case even if, as in
MBIA, the policyholder simply informs the insurers of the proposed settlement,
but fails to inform the insurers of any additional components, such as
an independent consultant. Any other result, according to the court, would
require the policyholder to revisit the claim with the nonparticipating insurer
each time negotiations about the same claim “take a new twist.” The court
noted that independent consultants are not a “rare component of regulatory
settlements” and should not be an unforeseeable component of the settlement
discussions. Thus, where the Insurers were notified of the proposed
settlement but failed to take part in settlement negotiations, the Policyholder
was entitled to recover the costs of the independent consultant’s investigation,
particularly where the Insurers failed to object after they learned of the
independent consultant component.
IMPLICATIONS
The MBIA decision is of particular significance to policyholders in
today’s economy, where lawmakers, governmental auditors and regulators
are becoming increasingly suspicious of corporate dealings and transac-
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CONTRACTS FOR DIRECTORS’ AND OFFICERS’ LIABILITY INSURANCE
tions, thereby requiring policyholders to incur substantial investigation
and compliance costs. As illustrated in MBIA, the costs of such regulatory
suspicion and investigation should be covered under contracts for Directors
& Officers liability insurance.
The decision is also significant because it broadly interprets the definition
of “Securities Claims” and “Securities Defense Costs,” thereby suggesting
that other fees and costs associated with a covered Directors &
Officers liability claim likewise should be covered under contracts for Directors
& Officers liability insurance.
Finally, the MBIA decision underscores the importance of keeping an
insurer informed, even when the insurer denies coverage, defends under a
reservation of rights or chooses to opt out of settlement negotiations. Although
the policyholder ultimately prevailed on the independent consultant
issue, the court stressed the importance of providing adequate notice
to the insurer regarding the claim under consideration for settlement.
NOTE
1
No. 10-0355-cv, 2011 U.S. App. Lexis 13402 (2d Cir. July 1, 2011).
825