The Subprime Mortgage Crisis and D&O Insurance: A New Frontier of Litigation

The fallout from the virtual collapse of the subprime mortgage lending industry has just begun. Early estimates of subprime losses start at $100 billion and may rise to several times that amount. (Fin. Times, Nov. 6, 2007, at p. 18). As the various participants in the subprime market ' borrowers, originators, institutional investors, financial institutions, hedge funds, underwriters, warehouse lenders, insurers, corporate investors, and the list goes on and on ' continue to uncover the extent of their losses, the blame game among these participants is likely to be played out in courts across the country.

The targets of this litigation ' directors, officers, and the corporation itself ' will, more likely than not, have directors and officers' liability insurance. Whether a D&O policy will afford coverage for the litigation resulting from the collapse of the subprime mortgage lending industry is yet to be seen. As discussed below, there are several policy provisions that are likely to be relevant in the subprime context. Because coverage follows liability, an understanding of the potential coverage issues first requires an understanding of the claims themselves.

To date, numerous lawsuits have been filed against a variety of participants in the subprime market. By way of example, in late October 2007, two lawsuits were filed against Merrill Lynch & Co. and its directors and officers. The claims arose out of Merrill Lynch's involvement in the securitization of subprime (as well as other residential and nonresidential) loans, which were bundled together and resold to investors in the secondary market through various financing vehicles, and the subsequent investment in those securities. The first lawsuit is a class action alleging violations of the federal securities laws (Life Enrichment Foundation v. Merrill Lynch & Co., No. 07 CIV 9633 (S.D.N.Y.)), while the second lawsuit is a shareholder's derivative action alleging breaches of fiduciary duties (Patricia Arthur, Derivatively on Behalf of Merrill Lynch & Co., v. E. Stanley O'Neal, et al., No. 07 CIV 9696 (S.D.N.Y.)). The factual allegations giving rise to both lawsuits are virtually identical.

In 2006 and 2007, Merrill Lynch was allegedly one of the leading underwriters for Collateralized Debt Obligations ('CDOs') deals earning more than $800 million in fees from deals valued at more than $93 billion. Despite alleged warning signs from its own equity analysts that a subprime mortgage crisis was looming, as late as 2006 Merrill Lynch not only purchased subprime lender, First Franklin Financial Corp. for more than $1 billion, but also continued to hold a substantial amount of CDOs. Although previously reporting strong net revenues, in early October 2007, Merrill Lynch announced a $4.5 billion charge fueled by subprime mortgage-related problems. A few weeks later, on Oct. 24, 2007, Merrill Lynch announced that it would be taking an additional $3.4 billion charge for a total write-down of $7.9 billion. According to plaintiffs, the $7.9 billion write down caused Merrill Lynch's stock to fall, resulting in economic loss to both Merrill Lynch and its investors.

As one would expect in a stock drop/class action lawsuit, plaintiffs allege violations of '10(b) of the Securities Exchange Act of 1934 and Rule 10(b)(5); and '20(a) of the Securities Exchange Act of 1934. More specifically, plaintiffs allege that, as a result of Merrill Lynch's statements, its stock price traded at inflated levels during the relevant class period (which is Feb. 26, 2007 to Oct. 23, 2007). In the shareholder derivative lawsuit, plaintiffs allege that: a) the directors and officers and, in particular, the audit committee, was responsible for Merrill Lynch's financial statements, which did not accurately describe its over-exposure to CDOs and subprime loans; and b) the directors and officers should never have permitted Merrill Lynch to assume millions of dollars worth of CDOs-related investments. As a result, plaintiffs allege that the directors and officers breached fiduciary duties of care, loyalty, and good faith; committed corporate waste; abused their control; and grossly mismanaged the company.

The Merrill Lynch lawsuits are not an isolated event. In October 2007, Luminent Mortgage Capital, a real estate investment trust, and two of its subsidiaries (collectively, 'Luminent') sued HSBC alleging that HSBC exploited the subprime market crisis to profit at Luminent's expense. (Luminent Mortgage Capital, Inc. et al., v. HSBC Securities, Inc., No. 07 CV 9340 (S.D.N.Y.)). Luminent alleges that it entered into certain repurchase agreements with HSBC. (Repurchase agreements are used by holders of securities to borrow against their position in the security. The party lending against the securities receives, in exchange for the loan, an interest in the security that is akin to a security interest. The lending arrangement is styled as a purchase of the securities by the lender upon the making of the loan and a repurchase of the securities by the borrower at the end of the loan.) As collateral for the loans, Luminent posted nine subprime mortgage bonds. Plaintiffs allege that HSBC manipulated 'an aberrational market as a pretext to unreasonably mark down' the value of the nine subprime mortgage bonds. As a result of the devaluation, HSBC demanded that plaintiffs increase the collateral for the repurchase agreements. When plaintiffs did not provide the additional collateral, HSBC allegedly initiated an auction of the bonds during which HSBC purchased the bonds at a deflated purchase price.

While the repurchase agreements, including the securities involved, are certainly complex, at its core, plaintiffs are alleging that HSBC took advantage of the subprime mortgage crisis to the detriment of plaintiffs. Consistent with such allegations, plaintiffs asserted the common law theories of breach of contract (the repurchase agreement); breach of the covenant of good faith and fair dealing; conversion (the nine subprime mortgage bonds); and unjust enrichment.

These lawsuits ' implicating very different aspects of the subprime mortgage lending industry ' demonstrate the breadth and scope of the litigation that will be generated from this crisis. Directors and officers, as well as the corporations themselves, will turn to their D&O policy for insurance coverage for this litigation. While coverage for any claim must be examined on a case-by-case basis, there are at least four exclusions in the D&O policy that are likely to be relevant in any such analysis.

Conduct Exclusions

D&O policies typically exclude coverage for claims arising out of an insured's: 1) dishonest or fraudulent acts; and/or 2) gaining of any profit to which he/she was not legally entitled. Claims arising out of the subprime mortgage crisis may include, as in Luminent, allegations that the defendants obtained a profit that they were not entitled to. Or, as in the Merrill Lynch cases, plaintiffs may allege that defendants made knowingly false or fraudulent misrepresentations regarding, among other things, the company's financial statements. Such allegations ' if proven ' could trigger the conduct exclusions.

The specific wording of the conduct exclusion can be critical in determining its applicability. Generally, conduct exclusions contain either 'in fact' or 'final adjudication' language: excluding coverage for claims arising out of the gaining 'in fact' of any profit or advantage to which an insured was not legally entitled; or excluding coverage for claims arising out of the gaining of any profit or advantage to which a 'final adjudication' adverse to an insured establishes that the insured was not legally entitled.

Where the exclusion contains 'final adjudication' language, courts have consistently held that the adjudication must take place in the underlying liability action for which coverage is sought, not in a collateral proceeding such as insurance coverage litigation. See, e.g., Atlantic Permanent Fed. Sav. & Loan Ass'n v. American Cas. Co., 839 F.2d 212, 217 (4th Cir.), cert. denied, 486 U.S. 1056 (1988). Accordingly, if the claims alleging prohibited conduct are settled before their adjudication, the exclusion does not apply. See, e.g., PepsiCo Inc. v. Continental Cas. Co., 640 F. Supp. 656, 659-60 (S.D.N.Y. 1986). In contrast, the 'in fact' language has been interpreted to mean that the exclusion is triggered if, in either the liability action or subsequent coverage litigation, an insurer can prove that the prohibited conducted occurred. Thus, if the claims are settled, the insurer can still litigate the applicability of the exclusion.

Given that the vast majority of conduct exclusions contain 'final adjudication' language, and given that most cases settle, while an insurer should reserve its rights to deny coverage based on the conduct exclusions, as a practical matter, it is unlikely that the 'final adjudication' will occur and thereby trigger the exclusion. That said, there is a line of cases ' commencing with Level 3 ' holding that claims for restitution and disgorgement are not insurable. Level 3 Commc'ns, Inc. v. Federal Ins. Co., 272 F.3d 908, 910 (7th Cir. 2001) (”loss' within the meaning of an insurance contract does not include the restoration of an ill-gotten gain'). In the event claimants are essentially seeking restitution or disgorgement from the insured, then a court may find, based on a Level 3 analysis, that the claim is uninsurable.

Insured v. Insured Exclusion

D&O policies exclude coverage for claims brought by one insured against another insured. While policies often contain numerous exceptions to this exclusion, two relevant carve-outs apply to the subprime litigation including claims brought: 1) derivatively, by or on behalf of the corporation; or 2) by a bankruptcy trustee.

Derivative Claims

Insurers except from the Insured v. Insured Exclusion shareholder derivative claims, but only if an insured is not participating ' in any way ' in the prosecution of those claims. An issue arises when a director or officer wears 'multiple hats,' i.e., a director or officer is also a shareholder of the company. In the event of a shareholder derivative lawsuit, insurers have successfully denied coverage where a current shareholder was also past director of the company. In Sphinx Int'l v. National Union Fire Ins. Co., 413 F.3d 1224 (11th Cir. 2005), a former director was a plaintiff in a shareholder derivative suit. Because the former director qualified as an insured under the policy, the Eleventh Circuit held that the exclusion was applicable to bar coverage.

In direct contrast to the outcome in Sphinx, a federal district court ' faced with arguably similar facts ' recently found that because each of the shareholders could have brought a separate action independent of the former director/shareholder's claim, the exclusion did not apply. Home Fed. Sav. and Loan Ass'n of Niles v. Federal Ins. Co., 2007 WL 2713060, at *5 (N.D. Ohio Sept. 14, 2007). While the Sphinx and Home Federal decisions reflect a split between the courts, the decisions also plainly demonstrate that directors and officers have multiple roles and capacities within a company. Given the complexity of the relationships ' and interrelationships ' between the participants in subprime mortgage transactions, and given the various roles of the directors and officers in those participants, the exclusion's applicability in the 'multiple hats' context will continue to be an issue for insurers and insureds alike.

Bankruptcy Trustee/Litigation Trusts

As of this writing, several participants in the subprime industry have sought bankruptcy protection. In such a situation, the bankruptcy court may appoint a trustee. One of a bankruptcy trustee's many functions is to investigate whether potential causes of action exist, including actions against the debtor's directors and officers. Given that a D&O policy may be one, if not the only, substantial asset of the bankruptcy estate, it is not unusual for the bankruptcy trustee to assert claims against the directors and officers.

In the mid-1990s, relying on the Insured v. Insured Exclusion, both the Eighth and Eleventh Circuits held that claims brought by a bankruptcy trustee on behalf of the debtor insured were excluded because the bankruptcy trustee 'stands in the shoes' of the insured. Reliance Ins. Co. v. Weis, 148 B.R. 575, 583 (E.D. Mo. 1992), aff'd 5 F.3d 532 (Table) (8th Cir. 1993); National Union Fire Ins. Co. v. Olympia Holding Corp., Case No. 1:94-cv-2081 (9/18/95), aff'd 148 F.3d 1070 (Table) (11th Cir. 1998). In direct contrast, the First, Third, Sixth, and Ninth Circuits have declined to apply the exclusion, finding that the bankruptcy trustee is separate and distinct from the insured debtor. See, e.g., In re County Seat Stores, 280 B.R. 319, 328 (Bankr. S.D.N.Y. 2002) (collecting cases). If, however, an insurer can demonstrate collusion among the bankruptcy trustee, debtor, or the directors and officers, a court is much more likely to consider applying the exclusion.

Related to the bankruptcy trustee issue, the debtor may assign certain claims against the directors and officers to a litigation trust. At least one court has held that an insured debtor cannot simply assign claims to a litigation trust to circumvent the Insured v. Insured Exclusion. R.J. Reynolds-Patrick County Memorial Hosp. v. Federal Ins. Co., 315 B.R. 674, 679 (Bankr. W.D. Va. 2003). Where, however, the litigation trust is prosecuting claims as an agent of the creditors, as opposed to the insured debtor, the claims are, by definition, derivative. As there is a carve-out for derivative claims that are brought without the assistance of any insured, unless the insurer can demonstrate that an insured is somehow assisting in the prosecution of the claim, the Insured v. Insured Exclusion will not apply. Pintlar Corp. v. Fidelity and Cas. Co., 205 B.R. 945, 948 (Bankr. D. Idaho 1997).

Breach of Contract Exclusion

As in Luminent, plaintiffs may assert various breach of contract claims against the parties to subprime mortgage transactions. Many D&O policies contain breach of contract exclusions that bar coverage for claims against an entity that arise out of express or oral contracts, unless the insured would have been liable in the absence of the contract. Even in the absence of an express exclusion, courts have reasoned that breach of contract claims are not insurable because the insured is simply being required to pay an amount it agreed to pay. Toombs NJ Inc. v. Aetna Cas. & Sur., 591 A.2d 304, 306 (Pa. Super. 1991) (neither the insured nor the insurer could reasonably have expected that insurance benefits would be available to cover the contract price of a business deal gone bad). Additionally, affording such coverage for breach of contract claims could create a moral hazard encouraging corporations to risk a breach of contract knowing that, in the event of such a breach, the D&O insurer would be responsible for any resulting damages. May Dept. Stores Co. v. Federal Ins. Co., 305 F.3d 597, 601 (7th Cir. 2002).

Other courts, however, have refused to allow a purported public policy rationale to override the express language of the policy. Verticalnet, Inc. v. U.S. Specialty Ins. Co., 492 F. Supp.2d 452, 460 (E.D. Pa. 2007) (in absence of an exclusion for contract-based claims, a D&O policy covered securities claims based on the insured corporation's breach of certain contractual obligations under a merger agreement). There is thus a split between the courts as to whether, in the absence of an express exclusion, contract-based claims are insurable on public policy grounds. Accordingly, whether this exclusion applies may very well depend on jurisdictional considerations.

Professional Services Exclusion

There appears to be a recent trend whereby D&O insurers are expressly excluding coverage for claims arising out of an insured's 'professional services.' This exclusion reflects the fact that coverage for such professional-related services is found elsewhere, i.e., an errors & omissions policy. More often than not, the term 'professional services' is not defined. Thus, the court will ultimately determine what acts or omissions fall within the insured's professional services and thus, the exclusion. Additionally, the exclusion often contains the broad language 'arising out of,' which arguably bars coverage for any claim that directly ' or even indirectly ' relates to the insured's professional services. In the context of the subprime industry, most, if not all, of the claims against the participants (and their directors and officers) arguably arise out of the subprime transactions, i.e., the participants' professional services. As with the other coverage issues, application of the exclusion will likely turn on the specific facts of the claim, as well as the jurisdiction.

Conclusion

These are only a handful of the potential D&O coverage issues arising out of the subprime litigation. Other policy provisions, including the definitions of Loss, Claim, and Wrongful Act, will certainly be relevant in a coverage analysis. And, given that many investors will likely assert that participants made misrepresentations in financial statements, insurers' attempts to rescind D&O policies may increase. In any case, all participants, including D&O insurers, are just beginning to get their arms around the potential exposure from the subprime mortgage lending industry's collapse. As estimates of losses continue to increase to well over $100 billion, and as the resulting litigation is likely to be daunting, it is inevitable that parties will turn to their D&O policies for cover. At that time, insurers and insureds alike will explore this new frontier of litigation.

Nancy D. Adams, CPCU, an attorney in the litigation section in Mintz Levin Cohn Ferris Glovsky and Popeo P.C.'s Boston office, is a member of the firm's insurance/reinsurance group and subprime practice group. The views expressed in the article are those of the author and not necessarily those of Mintz Levin or its clients.

The fallout from the virtual collapse of the subprime mortgage lending industry has just begun. Early estimates of subprime losses start at $100 billion and may rise to several times that amount. (Fin. Times, Nov. 6, 2007, at p. 18). As the various participants in the subprime market ' borrowers, originators, institutional investors, financial institutions, hedge funds, underwriters, warehouse lenders, insurers, corporate investors, and the list goes on and on ' continue to uncover the extent of their losses, the blame game among these participants is likely to be played out in courts across the country.

The targets of this litigation ' directors, officers, and the corporation itself ' will, more likely than not, have directors and officers' liability insurance. Whether a D&O policy will afford coverage for the litigation resulting from the collapse of the subprime mortgage lending industry is yet to be seen. As discussed below, there are several policy provisions that are likely to be relevant in the subprime context. Because coverage follows liability, an understanding of the potential coverage issues first requires an understanding of the claims themselves.

To date, numerous lawsuits have been filed against a variety of participants in the subprime market. By way of example, in late October 2007, two lawsuits were filed against Merrill Lynch & Co. and its directors and officers. The claims arose out of Merrill Lynch's involvement in the securitization of subprime (as well as other residential and nonresidential) loans, which were bundled together and resold to investors in the secondary market through various financing vehicles, and the subsequent investment in those securities. The first lawsuit is a class action alleging violations of the federal securities laws (Life Enrichment Foundation v. Merrill Lynch & Co., No. 07 CIV 9633 (S.D.N.Y.)), while the second lawsuit is a shareholder's derivative action alleging breaches of fiduciary duties (Patricia Arthur, Derivatively on Behalf of Merrill Lynch & Co., v. E. Stanley O'Neal, et al., No. 07 CIV 9696 (S.D.N.Y.)). The factual allegations giving rise to both lawsuits are virtually identical.

In 2006 and 2007, Merrill Lynch was allegedly one of the leading underwriters for Collateralized Debt Obligations ('CDOs') deals earning more than $800 million in fees from deals valued at more than $93 billion. Despite alleged warning signs from its own equity analysts that a subprime mortgage crisis was looming, as late as 2006 Merrill Lynch not only purchased subprime lender, First Franklin Financial Corp. for more than $1 billion, but also continued to hold a substantial amount of CDOs. Although previously reporting strong net revenues, in early October 2007, Merrill Lynch announced a $4.5 billion charge fueled by subprime mortgage-related problems. A few weeks later, on Oct. 24, 2007, Merrill Lynch announced that it would be taking an additional $3.4 billion charge for a total write-down of $7.9 billion. According to plaintiffs, the $7.9 billion write down caused Merrill Lynch's stock to fall, resulting in economic loss to both Merrill Lynch and its investors.

As one would expect in a stock drop/class action lawsuit, plaintiffs allege violations of '10(b) of the Securities Exchange Act of 1934 and Rule 10(b)(5); and '20(a) of the Securities Exchange Act of 1934. More specifically, plaintiffs allege that, as a result of Merrill Lynch's statements, its stock price traded at inflated levels during the relevant class period (which is Feb. 26, 2007 to Oct. 23, 2007). In the shareholder derivative lawsuit, plaintiffs allege that: a) the directors and officers and, in particular, the audit committee, was responsible for Merrill Lynch's financial statements, which did not accurately describe its over-exposure to CDOs and subprime loans; and b) the directors and officers should never have permitted Merrill Lynch to assume millions of dollars worth of CDOs-related investments. As a result, plaintiffs allege that the directors and officers breached fiduciary duties of care, loyalty, and good faith; committed corporate waste; abused their control; and grossly mismanaged the company.

The Merrill Lynch lawsuits are not an isolated event. In October 2007, Luminent Mortgage Capital, a real estate investment trust, and two of its subsidiaries (collectively, 'Luminent') sued HSBC alleging that HSBC exploited the subprime market crisis to profit at Luminent's expense. (Luminent Mortgage Capital, Inc. et al., v. HSBC Securities, Inc., No. 07 CV 9340 (S.D.N.Y.)). Luminent alleges that it entered into certain repurchase agreements with HSBC. (Repurchase agreements are used by holders of securities to borrow against their position in the security. The party lending against the securities receives, in exchange for the loan, an interest in the security that is akin to a security interest. The lending arrangement is styled as a purchase of the securities by the lender upon the making of the loan and a repurchase of the securities by the borrower at the end of the loan.) As collateral for the loans, Luminent posted nine subprime mortgage bonds. Plaintiffs allege that HSBC manipulated 'an aberrational market as a pretext to unreasonably mark down' the value of the nine subprime mortgage bonds. As a result of the devaluation, HSBC demanded that plaintiffs increase the collateral for the repurchase agreements. When plaintiffs did not provide the additional collateral, HSBC allegedly initiated an auction of the bonds during which HSBC purchased the bonds at a deflated purchase price.

While the repurchase agreements, including the securities involved, are certainly complex, at its core, plaintiffs are alleging that HSBC took advantage of the subprime mortgage crisis to the detriment of plaintiffs. Consistent with such allegations, plaintiffs asserted the common law theories of breach of contract (the repurchase agreement); breach of the covenant of good faith and fair dealing; conversion (the nine subprime mortgage bonds); and unjust enrichment.

These lawsuits ' implicating very different aspects of the subprime mortgage lending industry ' demonstrate the breadth and scope of the litigation that will be generated from this crisis. Directors and officers, as well as the corporations themselves, will turn to their D&O policy for insurance coverage for this litigation. While coverage for any claim must be examined on a case-by-case basis, there are at least four exclusions in the D&O policy that are likely to be relevant in any such analysis.

Conduct Exclusions

D&O policies typically exclude coverage for claims arising out of an insured's: 1) dishonest or fraudulent acts; and/or 2) gaining of any profit to which he/she was not legally entitled. Claims arising out of the subprime mortgage crisis may include, as in Luminent, allegations that the defendants obtained a profit that they were not entitled to. Or, as in the Merrill Lynch cases, plaintiffs may allege that defendants made knowingly false or fraudulent misrepresentations regarding, among other things, the company's financial statements. Such allegations ' if proven ' could trigger the conduct exclusions.

The specific wording of the conduct exclusion can be critical in determining its applicability. Generally, conduct exclusions contain either 'in fact' or 'final adjudication' language: excluding coverage for claims arising out of the gaining 'in fact' of any profit or advantage to which an insured was not legally entitled; or excluding coverage for claims arising out of the gaining of any profit or advantage to which a 'final adjudication' adverse to an insured establishes that the insured was not legally entitled.

Where the exclusion contains 'final adjudication' language, courts have consistently held that the adjudication must take place in the underlying liability action for which coverage is sought, not in a collateral proceeding such as insurance coverage litigation. See, e.g., Atlantic Permanent Fed. Sav. & Loan Ass'n v. American Cas. Co. , 839 F.2d 212, 217 (4th Cir.), cert. denied , 486 U.S. 1056 (1988). Accordingly, if the claims alleging prohibited conduct are settled before their adjudication, the exclusion does not apply. See, e.g. , PepsiCo Inc. v. Continental Cas. Co. , 640 F. Supp. 656, 659-60 (S.D.N.Y. 1986). In contrast, the 'in fact' language has been interpreted to mean that the exclusion is triggered if, in either the liability action or subsequent coverage litigation, an insurer can prove that the prohibited conducted occurred. Thus, if the claims are settled, the insurer can still litigate the applicability of the exclusion.

Given that the vast majority of conduct exclusions contain 'final adjudication' language, and given that most cases settle, while an insurer should reserve its rights to deny coverage based on the conduct exclusions, as a practical matter, it is unlikely that the 'final adjudication' will occur and thereby trigger the exclusion. That said, there is a line of cases ' commencing with Level 3 ' holding that claims for restitution and disgorgement are not insurable. Level 3 Commc'ns, Inc. v. Federal Ins. Co. , 272 F.3d 908, 910 (7th Cir. 2001) (”loss' within the meaning of an insurance contract does not include the restoration of an ill-gotten gain'). In the event claimants are essentially seeking restitution or disgorgement from the insured, then a court may find, based on a Level 3 analysis, that the claim is uninsurable.

Insured v. Insured Exclusion

D&O policies exclude coverage for claims brought by one insured against another insured. While policies often contain numerous exceptions to this exclusion, two relevant carve-outs apply to the subprime litigation including claims brought: 1) derivatively, by or on behalf of the corporation; or 2) by a bankruptcy trustee.

Derivative Claims

Insurers except from the Insured v. Insured Exclusion shareholder derivative claims, but only if an insured is not participating ' in any way ' in the prosecution of those claims. An issue arises when a director or officer wears 'multiple hats,' i.e., a director or officer is also a shareholder of the company. In the event of a shareholder derivative lawsuit, insurers have successfully denied coverage where a current shareholder was also past director of the company. In Sphinx Int'l v. National Union Fire Ins. Co. , 413 F.3d 1224 (11th Cir. 2005), a former director was a plaintiff in a shareholder derivative suit. Because the former director qualified as an insured under the policy, the Eleventh Circuit held that the exclusion was applicable to bar coverage.

In direct contrast to the outcome in Sphinx, a federal district court ' faced with arguably similar facts ' recently found that because each of the shareholders could have brought a separate action independent of the former director/shareholder's claim, the exclusion did not apply. Home Fed. Sav. and Loan Ass'n of Niles v. Federal Ins. Co., 2007 WL 2713060, at *5 (N.D. Ohio Sept. 14, 2007). While the Sphinx and Home Federal decisions reflect a split between the courts, the decisions also plainly demonstrate that directors and officers have multiple roles and capacities within a company. Given the complexity of the relationships ' and interrelationships ' between the participants in subprime mortgage transactions, and given the various roles of the directors and officers in those participants, the exclusion's applicability in the 'multiple hats' context will continue to be an issue for insurers and insureds alike.

Bankruptcy Trustee/Litigation Trusts

As of this writing, several participants in the subprime industry have sought bankruptcy protection. In such a situation, the bankruptcy court may appoint a trustee. One of a bankruptcy trustee's many functions is to investigate whether potential causes of action exist, including actions against the debtor's directors and officers. Given that a D&O policy may be one, if not the only, substantial asset of the bankruptcy estate, it is not unusual for the bankruptcy trustee to assert claims against the directors and officers.

In the mid-1990s, relying on the Insured v. Insured Exclusion, both the Eighth and Eleventh Circuits held that claims brought by a bankruptcy trustee on behalf of the debtor insured were excluded because the bankruptcy trustee 'stands in the shoes' of the insured. Reliance Ins. Co. v. Weis , 148 B.R. 575, 583 (E.D. Mo. 1992), aff'd 5 F.3d 532 (Table) (8th Cir. 1993); National Union Fire Ins. Co. v. Olympia Holding Corp. , Case No. 1:94-cv-2081 (9/18/95), aff'd 148 F.3d 1070 (Table) (11th Cir. 1998). In direct contrast, the First, Third, Sixth, and Ninth Circuits have declined to apply the exclusion, finding that the bankruptcy trustee is separate and distinct from the insured debtor. See, e.g., In re County Seat Stores, 280 B.R. 319, 328 (Bankr. S.D.N.Y. 2002) (collecting cases). If, however, an insurer can demonstrate collusion among the bankruptcy trustee, debtor, or the directors and officers, a court is much more likely to consider applying the exclusion.

Related to the bankruptcy trustee issue, the debtor may assign certain claims against the directors and officers to a litigation trust. At least one court has held that an insured debtor cannot simply assign claims to a litigation trust to circumvent the Insured v. Insured Exclusion. R.J. Reynolds-Patrick County Memorial Hosp. v. Federal Ins. Co. , 315 B.R. 674, 679 (Bankr. W.D. Va. 2003). Where, however, the litigation trust is prosecuting claims as an agent of the creditors, as opposed to the insured debtor, the claims are, by definition, derivative. As there is a carve-out for derivative claims that are brought without the assistance of any insured, unless the insurer can demonstrate that an insured is somehow assisting in the prosecution of the claim, the Insured v. Insured Exclusion will not apply. Pintlar Corp. v. Fidelity and Cas. Co. , 205 B.R. 945, 948 (Bankr. D. Idaho 1997).

Breach of Contract Exclusion

As in Luminent, plaintiffs may assert various breach of contract claims against the parties to subprime mortgage transactions. Many D&O policies contain breach of contract exclusions that bar coverage for claims against an entity that arise out of express or oral contracts, unless the insured would have been liable in the absence of the contract. Even in the absence of an express exclusion, courts have reasoned that breach of contract claims are not insurable because the insured is simply being required to pay an amount it agreed to pay. Toombs NJ Inc. v. Aetna Cas. & Sur. , 591 A.2d 304, 306 (Pa. Super. 1991) (neither the insured nor the insurer could reasonably have expected that insurance benefits would be available to cover the contract price of a business deal gone bad). Additionally, affording such coverage for breach of contract claims could create a moral hazard encouraging corporations to risk a breach of contract knowing that, in the event of such a breach, the D&O insurer would be responsible for any resulting damages. May Dept. Stores Co. v. Federal Ins. Co. , 305 F.3d 597, 601 (7th Cir. 2002).

Other courts, however, have refused to allow a purported public policy rationale to override the express language of the policy. Verticalnet, Inc. v. U.S. Specialty Ins. Co. , 492 F. Supp.2d 452, 460 (E.D. Pa. 2007) (in absence of an exclusion for contract-based claims, a D&O policy covered securities claims based on the insured corporation's breach of certain contractual obligations under a merger agreement). There is thus a split between the courts as to whether, in the absence of an express exclusion, contract-based claims are insurable on public policy grounds. Accordingly, whether this exclusion applies may very well depend on jurisdictional considerations.

Professional Services Exclusion

There appears to be a recent trend whereby D&O insurers are expressly excluding coverage for claims arising out of an insured's 'professional services.' This exclusion reflects the fact that coverage for such professional-related services is found elsewhere, i.e., an errors & omissions policy. More often than not, the term 'professional services' is not defined. Thus, the court will ultimately determine what acts or omissions fall within the insured's professional services and thus, the exclusion. Additionally, the exclusion often contains the broad language 'arising out of,' which arguably bars coverage for any claim that directly ' or even indirectly ' relates to the insured's professional services. In the context of the subprime industry, most, if not all, of the claims against the participants (and their directors and officers) arguably arise out of the subprime transactions, i.e., the participants' professional services. As with the other coverage issues, application of the exclusion will likely turn on the specific facts of the claim, as well as the jurisdiction.

Conclusion

These are only a handful of the potential D&O coverage issues arising out of the subprime litigation. Other policy provisions, including the definitions of Loss, Claim, and Wrongful Act, will certainly be relevant in a coverage analysis. And, given that many investors will likely assert that participants made misrepresentations in financial statements, insurers' attempts to rescind D&O policies may increase. In any case, all participants, including D&O insurers, are just beginning to get their arms around the potential exposure from the subprime mortgage lending industry's collapse. As estimates of losses continue to increase to well over $100 billion, and as the resulting litigation is likely to be daunting, it is inevitable that parties will turn to their D&O policies for cover. At that time, insurers and insureds alike will explore this new frontier of litigation.

Nancy D. Adams, CPCU, an attorney in the litigation section in Mintz Levin Cohn Ferris Glovsky and Popeo P.C.'s Boston office, is a member of the firm's insurance/reinsurance group and subprime practice group. The views expressed in the article are those of the author and not necessarily those of Mintz Levin or its clients.