Policy Questions Remain On D&O Fraud

He concluded that the more recent Alstrin ruling, in which the Delaware district court rejected an insurers coverage defenses in a partial settlement of a federal securities claim, would have more impact on D&O insurers than California Amplifier.

In California Amplifier, the California Court of Appeal held in favor of an insurers argument that coverage of a state law securities fraud settlement was precluded by Cal. Insurance Code, Section 533. Section 533 says that an "insurer is not liable for a loss caused by the willful act of the insured." Reasoning that the violations of the sections of the California Corporations Code alleged in the underlying class action required "knowing and intentional conduct," the Court concluded that such conduct would constitute a "willful act."

While there is nothing precisely inconsistent between the reasoning of the courts in each case, unlike Mr. Henkin, I find Alstrin to be the case of flawed judicial analysis.

In his article, Mr. Henkin accurately described the holding and reasoning in California Amplifier. But he criticized the Court for focusing solely on the allegations in the underlying claim (that the defendants had made false statements to the market to inflate their companys stock price) and not considering the fact the claim was disposed via settlement.

Because the underlying case was settled, any willful conduct that would trigger the application of an intentional fraud exclusion was not established, but instead was read into the policy by virtue of Section 533 of the California Insurance Code, he opined.

He recognized, as did the Court, that the result would have been different if the underlying claims alleged violations of the federal securities laws that could be proven upon a showing of some sort of recklessness. But he seemingly ignored the fact that the Court recognized violations of the state of Californias securities code, which were at issue here, to be only grounded in intentional misconduct.

An examination of several alternative scenarios involving combinations of settlements, adjudicated liability on the merits, federal securities laws violations, and the California Corporations Code sections at issue in California Amplifier will best illustrate the fundamental soundness of the Courts decision.

First, the typical federal securities law claim is, at its core, based upon a violation of Section 10 (b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Although there are different standards for establishing the scienter requirement for 10b-5 liability among the various circuits, none establishes a requirement more stringent than Californias Ninth Circuit standard of "deliberate recklessness."

The 9th Circuit standard arguably falls short of the state law requirements of the kind of "knowing and deliberate" conduct that California Amplifier held to be the equivalent of "willful" and thus proscribed as uninsurable.

Second, in a settlement scenario, there is absolute consistency in the results that a federal securities fraud settlement would be covered by most D&O insurance policies, while one arising from California Corporation Code violations would not.

In the former case of a federal securities fraud settlement, the fact that liability may result from reckless conduct precludes the application of Section 533 or any policy exclusion for intentional misconduct, particularly one that requires a final adjudication of such misconduct.

In the latter case of a California state law securities fraud settlement, there can never be covered liability, and a number of courts have held that an insurer need not cover a settlement in these situations, regardless of whether or not the policys exclusionary language requires a final adjudication. These include the following decisions by federal and state courts applying New York law, and which would likely be followed in other jurisdictions: Davis v. Home Ins. Co. (S.D.N.Y., June 26, 1995); Pepsico v. Continental Cas. Co. (S.D.N.Y. 1986); Tartaglia v. Home Ins. Co. (App. Div. 1997).

In a substantive and final adjudication context, coverage simply depends upon what has been adjudicated. This should be a presumably moot issue in a California Corporations Code case, because there is either a no liability situation or one based upon uninsured and uninsurable conduct. In a federal securities case, where it should be noted that trials on the merits rarely occur, it is possible that intentional misconduct may be established even though only recklessness is required as a matter of law.

Although, as Mr. Henkins article reported, state securities fraud claims like those asserted in California Amplifier are now pre-empted by federal law enacted in 1998, there remain a relative handful of pending California Corporations Code suits where this coverage decision has direct application.

Moreover, both the reasoning and result of the Court should extend far beyond this limited area in setting precedent. Insurers will argue that the reasoning should be followed by California and other courts whenever coverage is being sought for a settlement (and perhaps defense costs as well) in a claim where the only basis for liability is intentional or otherwise uninsured or uninsurable conduct.

Turning to Alstrin, this was a case in which the underlying litigation involved allegations of violations of the federal securities fraud laws and thus, as discussed above, violations that could be sustained upon a showing of reckless misconduct. The D&O insurers fraud exclusion did not require a final adjudication in order to be applicable, but rather was of the kind that only required the fraud, dishonesty or intentional misconduct at issue to be established "in fact".

Upon the settlement of the underlying litigation, the insurer sought to deny coverage on the basis, among other things, that there was "in fact" the type of conduct that would trigger the exclusion.

The Court never reached the issue of whether there was the requisite "in fact" conduct. Instead, it ruled that the exclusion could never apply to a securities fraud claim because that would render the coverage illusory.

In essence, the Court suggested that because coverage for securities fraud claims are granted by virtue of the basic insuring agreement of the policy, that coverage cannot be totally eliminated by application of an exclusion.

That reasoning is flawed in two major respects.

First, exclusions in an insurance policy oftentimes either significantly delimit the grant of coverage contained in the policys basic insuring agreement or, in certain claim situations, eliminate it entirely. While the Court is essentially correct that coverage would be illusory if there were an exclusion that took away coverage in its entirety in all possible claim scenarios that could arise, that is not the situation at issue in Alstrin.

Second, while the exclusion certainly would be applicable if there were "in fact" intentional wrongdoing, it might not apply if the insurer could not establish any culpable conduct beyond recklessness. Yet, recklessness would be sufficient to support liability under the federal securities laws and be one of several factors justifying a decision to settle the underlying litigation.

Thus, the most interesting issues are those that the Court never reached, including the following:

How could or would the "in fact" requirement be applied in the context of a settlement of the underlying claim?

Could the insurer establish the application of the exclusion on its own, or must it seek such to be established though a neutral fact finder such as a court or arbitral forum?

With so many eyes focused on securities fraud and corporate governance claim issues these days, this might not have been the worst case for insurers and policyholders as a whole to have received a little judicial guidance on these issues. Unfortunately, that will have to await another case at another time.

Joseph P. Monteleone is vice president and claims counsel at Hartford Financial Products in New York City.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, October 7, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.