Recent D&O Coverage Decisions At Odds

Companies and their managements, particularly in the high-techsector, thought that the Private Securities Litigation Reform Actof 1995 would lead to less securities litigation. Yet the burstingof the tech bubble and the corporate meltdowns that followedresulted in 2001 becoming a banner year for securities fraud classactions.

In response to these developments, insurers that issue directorsand officers liability policies are raising rates and trying tolimit coverage. These efforts make two recent decisions regardingattempts to limit coverage for “intentional” fraud criticallyimportant.

The first is California Amplifier Inc. v. RLI Ins. Co.,in which the California Court of Appeal affirmed a lower courtdecision that coverage of a state law securities fraud settlementunder an excess D&O policy was precluded by Cal. InsuranceCode, Section 533.

The second is Alstrin v. St. Paul Mercury Ins. Co., inwhich the United States District Court for the District of Delawarerejected defenses to coverage raised by the D&O insurer basedon an intentional fraud exclusion.

Although the cases were strikingly similar, their results wereanything but.

California Amplifier had one primary and two excess D&Opolicies that insured its directors and officers against liabilityfor, among other things, violations of state securities laws. RLIwas one of the excess insurers.

In 1997, California Amplifier and two of its officers were namedas defendants in a class action alleging violations of Cal.Corporations Code Sections 25400(d) and 25500. The plaintiffsalleged that the company and two officers had made false statementsto the market about California Amplifiers stock as part of a schemeto artificially inflate its price.

The case settled at the beginning of the trial, with CaliforniaAmplifier, the primary D&O insurer, and one of the excessinsurers contributing to the settlement. RLI, however, deniedcoverage and refused to pay any part of the settlement.

California Amplifier and the two officer defendants then suedRLI in the Superior Court of Ventura County, alleging claims forbreach of the excess policy, bad faith refusal to respond to theirdemand for payment, and unfair business practices. RLI responded bymoving for judgment on the pleadings, asserting that the classaction claims were uninsurable under Cal. Insurance Code Section533.

Section 533 provides that an “insurer is not liable for a losscaused by the willful act of the insured; but he is not exoneratedby the negligence of the insured, or of the insureds agents orothers.”

(Other states have similar statutes. For example, North Dakotasis virtually identical to Californias Section 533. In addition,some states have similar provisions as a matter of common law. Forexample, a 1985 Supreme Court of New York decision in Austro v.Niagara Mohawk Power Corp., held that “indemnificationagreements are unenforceable as violative of public policy to theextent that they purport to indemnify a party for damages flowingfrom the intentional causation of injury.”)

The trial court granted RLIs motion. On appeal, the CaliforniaCourt of Appeal, Second District, affirmed in December 2001.

The Court of Appeal first engaged in an extensive analysis ofwhat mental state was required for the claims asserted in the classaction. The court determined that the class action claims dependedon conduct that was “knowing and deliberate,” and concluded thatsuch conduct would constitute a “willful act” under Section 533.For that reason, the court held that the claims were notinsurable.

In reaching this decision, however, the court suggested that itagreed with a federal decision holding that, because securitiesfraud claims under Section 10(b) of the Securities Exchange Act of1934 can be based on reckless conduct, Section 533 did not precludecoverage of such claims. Coverage for claims brought under the 1934Act might be precluded only if it was proven that the defendantsconduct was more than reckless, the California Court of Appealsuggested in Amplifier.

It should be noted that in performing its analysis, theCalifornia Amplifier Court focused only on the elements of theclaims that were alleged. It did not acknowledge that there was noproof of any of the elements nor any finding of liability. That thecase was settled, and thus no “willful conduct” was established,seems to have been of no moment.

This gives the Alstrin decision, which was handed downjust over one month after California Amplifier, evengreater importance. Despite the fact that the factual settings ofCalifornia Amplifier and Alstrin are remarkablysimilar, its legal setting–and its result–are remarkablydifferent.

In Alstrin, the corporation had a primary and twoexcess D&O policies, and an overlapping D&O policy issuedby National Union Fire Insurance Company of Pittsburgh, whichprovided separate coverage. The plaintiffs reached a partialsettlement in the underlying federal securities litigation andsought coverage under the National Union policys “Run-Off”endorsement. National Union contended that the intentional fraudexclusion in its policy barred the plaintiffs claims.

The most immediate difference can be seen by comparing Section553 with Exclusion 4(c) of the Alstrin policy. The CaliforniaAmplifier court seems to have held that Section 553s exclusionis triggered by the mere assertion (or settlement) of a claim thatdepends upon willful conduct. In contrast, the Alstrinpolicy excluded claims “arising out of, based upon or attributableto the committing in fact of anydeliberate fraud,” and NationalUnion contended that the exclusion was only triggered by a judicialdetermination of deliberate conduct.

The district court made short work of this exclusion.

Noting that the policy appeared on its face to provideunrestricted coverage for securities claims, including securitiesfraud claims, the court held that the insurer could not givecoverage with one hand and then appear to take away most of thatcoverage with the other, noting that insureds would not read thebroad securities coverage to include only claims based on recklessor negligent behavior. The court therefore concluded that NationalUnion could not rely on the exclusion to deny coverage.

Probably the most significant question raised by the remarkablydifferent outcomes of California Amplifier andAlstrin is which decision is likely to have the moresignificant impact on the D&O field. Because of a recent changein federal law, it is likely that California Amplifierwill be the anomalous decision.

Congress passed the Securities Litigation Uniform Standards Actin 1998. The SLUSA was intended to preempt certain state-lawsecurities class actions, allow the removal of such actions tofederal court, and allow federal courts to stay discovery incertain state-court actions. In particular, the SLUSA requiresremoval and dismissal of a (i) “covered class action” that is (ii)based on state law and (iii) alleges a misrepresentation oromission of a material fact or deceptive act (iv) in connectionwith the purchase or sale of a “covered security.”

A “covered security” is, among other things, a security that islisted (or authorized for listing) on the New York Stock Exchange,the American Stock Exchange, or the National Market System of theNasdaq Stock Market. The term “covered class action” includes bothtraditional class actions under state law analogs of Federal Ruleof Civil Procedure 23 and sufficiently large groups of parallelindividual actions. When state law claims are covered by SLUSA,they must be dismissed.

Because SLUSA is now in effect, claims like those at issue inCalifornia Amplifier are unlikely to arise again in theclass action context, and so the result in CaliforniaAmplifier is unlikely to recur in the securities arena. If thecomplaint at issue in California Amplifier were filedtoday, it would be subject to immediate removal and dismissal underSLUSA.

Because it was filed in June 1997, just under eighteen monthsbefore SLUSA became effective, the defendants could not takeadvantage of SLUSAs preemption of state law securities classactions.

Although Congress intended SLUSA to close loopholes left afterthe Private Securities Litigation Reform Act of 1995 was enacted,it appears to have done much more. By preempting state law classactions based on statutes that require “willful” acts for liabilityto attach, SLUSA may also take a great deal of the potential stingout of the California Amplifier decision for insureds.

Douglas Henkin is a partner in the litigation department ofMilbank, Tweed, Hadley & McCloy LLP. He is resident in MilbanksNew York office and his practice includes securities and structuredfinancial product litigation.

Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, May 6, 2002.Copyright 2002 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.