Unprecedented banking and financial company failures and hastilyarranged buyouts by regulators to avoid insolvencies have left thefinancial markets reeling. The Federal Reserve and the TreasuryDepartment formulated bailouts of companies once thought solid.Congress wrangled with the $700 billion rescue package to avertfurther disaster. Stockholders of once-steady entities such asWashington Mutual, Wachovia, or AIG find investments lost, and someon the brink of retirement discover that their nest eggs haveshrunk by 25 percent or more. As the affected masses search forpeople to blame and assets to tap, suits against directors,officers, accountants, and even loan agents and appraisers continueto mount.

Given the more than $230 billion in write-downs from thesubprime mortgage crisis in the first half of 2008, an inevitablebarrage of litigation ensued. During the first three months of 2008alone, 170 subprime-related lawsuits were filed in Federal Court.Nearly half of these suits were filed in New York and California.One half of the lawsuits involved putative class actions byborrowers versus lenders and mortgage brokers alleging (among otherthings) discriminatory lending practices, improper charges, andinadequate disclosures.

In January 2008, Bear Stearns estimated that directors andofficers (D&O) insurers may face $9 billion in claim-relatedcosts. Bear Stearns' own officers and directors were subject to asuit against them, which was filed within hours of the announcedbailout sale to J. P. Morgan (Eastside Holdings, Inc. v. BearStearns). Other subprime-related securities lawsuits have beenbrought against AIG, Citigroup E-Trade Financial Corp., HSBCHoldings, Movies Company, Toll Brothers, and Washington Mutual,Inc. Of the many cases filed in the past year, almost all of themname individual directors or officers as defendants.

But are the insurers taking note of the burgeoning litigation?Have the underwriters anticipated such claims with policy languagethat excludes claims arising out of fraud, dishonest acts, orimproper personal profit? Are claim professionals ready toinvestigate the facts to make the proper coverage determinations?Will other insurers face the same fate as AIG?

When faced with a D&O claim made against a director or anofficer of a Fortune 500, a small privately held firm, or an errorsand omissions (E&O) claim against a loan broker, insurers mustbe prepared to apply policy language and investigate the facts.This can be accomplished by answering simple questions.

Does the Policy Language Limit Coverage?

D&O and E&O policies contain “dishonesty exclusions.”The related policy language may resemble the following: a) Thegaining of any profit, remuneration, or advantage to which theinsured was not legally entitled; or b) any criminal ordeliberately fraudulent act, error or omission by an insured, ifevidenced by any judgment, final adjudication, alternative disputeresolution proceeding, or a document or written statement by aninsured.

Many policies do not include the qualifying phrase, “or adocument or a written statement by an insured.” Instead, numerouspolicies contain language that the exclusion only applies, “if ajudgment or other final adjudication adverse to the insuredestablishes such act, omission, or willful violation.”

A secondary issue arises where the policy provides that no factpertaining to, knowledge possessed by, or conduct by any insuredindividual shall be imputed to any other insured individual.Essentially, this means that if one director or officer commits awrongful act resulting in an illegal profit, then the innocentdirectors or officers are not subject to a loss of coverage.

An insurance company may be defending D&O litigation — orreimbursing an insured for the defense and potential indemnitypayments in litigation — until there is a final adjudicationestablishing the application of the dishonesty exclusion.

Many D&O policies also contain language excluding “personalprofit.” The language usually states that such losses are excludedarising out of the gaining “in fact” of any personal profit oradvantage to which the insured is not legally entitled.

Some courts have interpreted this “in-fact” requirement asmeaning a final adjudication. (PMI Mortgage Ins. Co. v. AmericanInternational Specialty Lines Ins. Co). In PMI Mortgage, theinsurance company was required to reimburse an insured's defensecosts and amounts paid to settle an underlying D&O lawsuitbrought about by consumers against a mortgage insurer, even thoughthe allegations of the complaint sought recovery of profit to whichthe insured was not legally entitled. During the trial, the insurercould not produce evidence of the coverage action to establish thatthe insured paid a settlement amount allocated to an excludedpersonal profit. Other jurisdictions have not required a finaladjudication to satisfy the “in-fact” requirement.

Therefore, the application of the exclusions related todishonest acts or personal profit require that the insurer alterthe evidence to establish that defense and indemnity reimbursementsought by the insured is excluded. Depending on the policylanguage, this may require a final adjudication in the underlyingaction against the insured. Waiting for the underlying action to goto final judgment could be a costly proposition for an insurer. Assuch, the claim professional needs to investigate to obtain theevidence to determine if the insurer can establish “in fact” anillegal personal profit or establish in a separate declaratoryrelief action that the dishonesty exclusion applies.

What Lies Beneath

An insurer's investigation entails a thorough analysis of theoperations of its insured. This begins with a complete review ofthe underwriting materials from the company and documents from theinsurance agent or surplus lines broker that contain all the factsabout the insured's operations.

Next, the claim professional will need to analyze the lawsgoverning the particular industry. If there is an allegation ofpredatory lending practices, then the professional will need todetermine what, if any, regulations the insured has allegedlyviolated. One should also consider the common industry practice asto the application of fees or the duties of disclosure. Do thedamages seek excluded fines and penalties? What is the maximumpenalty and how is this calculated? The claim professional needs tobe able — at an early stage — to allocate the potentially soughtdamages to amounts covered under a policy, and to amounts excludedas the product of a dishonest act, a personal profit, or a fine orpenalty.

Insurers must not overlook easy information sources, such as acompany web site or company marketing material for a closely heldcompany like a local mortgage broker. For a large enterprise, payattention to annual reports or other publicly filed documents.Interviews of company employees may fill in the gaps wheredocuments leave off. Depending on the complexity of the case and onthe policy limits exposure, carriers should also consider forensicaccounting experts to assist in understanding the exposure. It maybe prudent to ask the expert to assist in a damage analysis for thepotential application of policy exclusions to a settlement demand,settlement payment, or a judgment against an insured.

Duty of the Insurer

The insurer needs to respond to a tender from a policyholder inan expeditious manner. Some state-specific claim regulationsestablish time periods that a carrier must follow when respondingto an insured and making an initial coverage determination.Preliminarily, the insurance company's response will depend onwhether the policy is a straight reimbursement policy and if thepolicy contains a “duty-to-defend” provision.

Where the policy contains a duty to defend — as is often thecase in D&O policies specifically tailored to closely heldcompanies — the insurer would do best to defend while itinvestigates the claim. A letter specifically tailored to set forththe coverage position of the insurance company should beformulated. This should include the pertinent exclusions, theconditions and provisions of the policy, the definition of loss,and the requirements that the underlying suit must seek damages asopposed to fines or penalties. The carrier can then request theinsured's cooperation in providing information, books, records, andother documents from the company that relate to the underlyingsuit. It can also ensure that its employees are available forinterviews and can opt to correspond with its insured via coveragecounsel. This will insulate the insurance company through theattorney/client privilege from the thoughts, comments, and opinionsof its coverage counsel. It is important to note that the natureand extent of the attorney/client privilege varies fromjurisdiction.

In limited circumstances, depending upon the lack of cooperationfrom the policyholder, it may be necessary to file a specificallytailored complaint for declaratory relief. When the policyholderwill not communicate with the insurer, the only remaining optionmay be seeking court assistance. Filing a declaratory relief actionallows the carrier to obtain facts through the litigation processwhere the policyholder was unwilling or unable to provide thenecessary documentation for the carrier to determine coverage. Thecarrier does not want to be in a position where there is a demandto indemnify from the policyholder for a questionably coveredclaim, and the carrier has no facts to evaluate its coverage or tochallenge the demand.

The Power of Exclusion

The impact of a subprime crisis on insurance companies willlikely be minimized by the effect of exclusions based on the fraudof the insured — whether the dishonest-acts exclusion or thepersonal-profit exclusion applies. Insurers have drafted thislanguage anticipating E&O and D&O claims. However, the needfor a final adjudication of the facts to apply the exclusionsrequires the insurer to be vigilant in its investigation from theonset.

The insurer will be required to either wait for the conclusionof an expensive underlying action or be prepared to litigatecoverage in a coverage action. The insurer will then need toestablish the evidence to allocate the damages sought to theexclusion. A thorough and early investigation will allow theinsurer to meaningfully discuss apportionment of loss with itsinsured while underlying action proceeds along, rather than waituntil the insured settles or faces a final judgment that may or maynot be sufficiently particular to allow the application ofexclusion.

Finally, conducting a thorough investigation will permit aninsurer to properly reserve the losses and allow actuaries to pricepremiums moving forward to maintain the financial solvency of theinsurance company.

Stephen Erigero is a partner in the Los Angeles office ofRopers Majeski Kohn & Bentley. He practices in areas ofinsurance coverage and professional liability. Erigero may bereached at 213-312-2000, [email protected], www.rmkb.com.