Subprime Mortgages and D&O Coverage: Will Insurers Pay and for What?

As the wave of litigation related to subprime defaults builds momentum, the people and institutions targeted by that litigation are looking to their insurers for reimbursement of the costs of defending those actions and any resulting liabilities. In particular, defendants in such actions are seeking, and will continue to seek, coverage under their directors and officers ('D&O') policies. Indeed, D&O insurers are likely to face unprecedented claims in connection with the subprime crisis. One insurance industry observer believes that 'subprime-linked payouts by providers of directors and officers insurance are expected to be higher than the payouts for any other single event in history.' See Mary Thomson, D&O Insurers Take Hit from Subprime Payouts, cnbc.com (Feb. 12, 2008), at www.cnbc.com/id/23130521.

There are bound to be insurance disputes associated with subprime issues given the vast exposure and number of claims facing D&O insurers. At this early stage, however, it is difficult to predict the coverage issues that will present themselves most frequently in connection with the subprime crisis. As with other liabilities, coverage litigation related to subprime liabilities is likely to lag behind the present wave of underlying claims. Moreover, the types of claims arising out of the subprime crisis are incredibly diverse, and any individualized coverage analysis must turn on the unique facts and circumstances surrounding a particular claim.

Recurring D&O issues, however, have arisen in connection with prior 'meltdowns,' such as the securities class actions and shareholder derivative suits brought in the wake of the 'savings and loan' scandal of the 1980s and 1990s ('S&L Scandal') and the more recent 'accounting irregularities' involving Enron and Arthur Andersen, among others. As one example, D&O Insurers attempted to mitigate losses related to the savings and loan scandal by adding a regulatory exclusion to their policies. A typical regulatory exclusion seeks to exclude coverage for claims by regulators of financial institutions, including the Federal Deposit Insurance Corporation and the Federal Savings & Loan Insurance Corporation. See John F. Olson & Josiah O. Hatch, III, Director & Officer Liability: Indemnification and Insurance '12:15 (2003). Interpretations of regulatory exclusions, however, have been mixed. Some courts have upheld them as written, while others have refused to apply them on public policy grounds. Id. Compare, e.g., Fed. Deposit Ins. Corp. v. Aetna Cas. & Sur. Co., 903 F.2d 1073, 1078 (6th Cir. 1990), with Am. Cas. Co. of Reading, Pa. v. Fed. Deposit Ins. Corp., 677 F. Supp. 600, 604 (N.D. Iowa 1987). Similarly, it is possible that insurers will attempt to draft an exclusion aimed at limiting, or excepting from coverage D&O claims related to subprime liabilities, particularly if current losses continue to escalate.

In any event, whereas D&O coverage in the subprime context remains largely untested, there is a body of case law interpreting D&O policies in analogous circumstances. Some of the issues that have presented themselves prominently in prior cases include:

• Whether coverage was barred by the policyholder's purported failure to comply with the D&O policy's notice requirements;
• Whether the conduct at issue was ultra vires and thus outside of the D&O policy's coverage grant;
• Whether coverage was defeated by exclusionary provisions concerning fraudulent, criminal, or illegal conduct;
• Whether coverage was excluded by the so called 'insured v. insured' exclusion, which limits coverage for claims brought by one insured against any other insured under the D&O policy; and
• Whether policy rescission was warranted based upon inaccuracies in the policy application.

Accordingly, it is not unreasonable to speculate that these issues may also become prominent in connection with the present subprime meltdown.

Background: Roots of the Crisis and the Resulting Litigation

The subprime mortgage crisis has many facets, which are reflected by the quantity and variety of lawsuits that have arisen in recent months. Simply put, the crisis resulted from defaults on 'bad' home loans to risky borrowers characterized as 'subprime.' As compared with 'prime' borrowers, subprime borrowers are more likely to default on their loans due to poor credit history, low income coupled with high consumer debt, and/or other risk factors. See Faten Sabry & Dr. Thomas Schopflocher, The Subprime Meltdown: A Primer 2 (NERA Economic Consulting June 21, 2007), available at http://www.nera.com/.

Accordingly, subprime borrowers must pay a premium on their loans in the form of a higher interest rate. The interest rate is either fixed or adjustable, and very often (and problematically) a combination of both. Subprime borrowers are often provided an introductory, lower rate ' sometimes referred to as a 'teaser' rate ' followed after several months by a rate that adjusts (typically upward) on a regular basis. In addition, because subprime borrowers often have a low income to debt ratio, and consequently are less likely to have substantial savings, they tend to make smaller down payments.

The result of the aforementioned arrangement is a high loan-to-value ratio ' sometimes as high as 100% ' that provides less of an 'equity cushion' in the event of a slowdown or downturn in the market appreciation of residential real estate. This equity deficit gives the borrower no alternative but default (instead of refinancing) when a market slowdown occurs and the borrower cannot make his mortgage payments. The situation is often compounded when the borrower's monthly payment increases under the terms of an adjustable rate mortgage. It also can deprive the lender of the value of its collateral when it is forced to foreclose. See Id.

Subprime loans are not new. They have historically represented 10% to 12% of the mortgage market, but their prevalence in the recent market was unprecedented. See Victoria Wagner, A Primer for the Subprime Problem, Business Week, March 13, 2007, available at www.businessweek.com/investor/content/mar2007/pi20070313_837773.htm. At 20% (and a staggering 40% of the adjustable rate and interest-only loan market), subprime lending rates have far exceeded their historically normal levels. See Id. Accordingly, the recent housing bust and the ensuing fallout of defaults and foreclosures have led to lawsuits against lending institutions, underwriters, and mortgage brokers by aggrieved borrowers alleging predatory lending practices, misrepresentation, disclosure violations, fraud, and unfair trade practices. Additionally, subprime plaintiffs have alleged violation of consumer protection laws based upon overly complex and/or poorly explained mortgage instruments as a result of 'payment shock' after the expiration of the 'teaser' rates. See Sabry & Schopflocher, supra, at 11 & 13 (Fig. 8). To the extent that federal and state 'holder rules' make them liable, the present holders of the loans, in addition to the loans' originators, could be targeted by these lawsuits, as might assignees and even investment banks, that arguably ratified, facilitated, or acquiesced in the lenders' conduct in the process of financing or securitizing the loans. These consumer-debtor suits may come in the form of a class action, see, e.g., Plumbers' Union Local No. 12 Pension Fund, Individually and on Behalf of All Others Similarly Situated v. Swiss Reinsurance Co. et al., No. 08 CV 10958 (S.D.N.Y. Feb. 27, 2008) (Complaint), and may, in turn, spawn indemnification actions as investment banks assert indemnity claims against lenders, who in turn will seek indemnification from the mortgage brokers who marketed and sold the loans to consumers.

Other types of lawsuits implicating subprime lending practices have already been filed or are expected to be filed. For instance, as banks and lending institutions have suffered the financial consequences of subprime loans gone bad, shareholders have brought class actions for fraud against banks and their directors and officers under federal securities laws for their questionable valuations, alleged financial misrepresentations and omissions, and poor underwriting standards. See Sabry & Schopflocher, supra, at 12, 13 (Fig. 8); Foreclosure Fallout: Subprime Lending Crisis Adds to Banks' Insurance Headaches, ABA Banking Journal, Jan. 2008, at 36. Similarly, lending institution employees have sued their employers ' and their directors and officers ' under the federal Employee Retirement Income Security Act ('ERISA') when their retirement savings, invested in company stock, have all but disappeared. Id. at 36, 38.

The landscape receives an added layer of complexity because of the practice of securitization. Theoretically, securitization of subprime debt increases credit availability and liquidity in the mortgage market. See Sabry & Schopflocher, supra, at 4-8. In short, the originator of a subprime loan often seeks to sell the loan to a trust, which underwrites debt securities by pooling the loans into bonds called mortgage-backed securities. The trust sells the securities to an underwriter or investment bank, which in turn sells the securities to investors ' typically, mutual funds, hedge funds, insurance companies and/or pension plans. To make the subprime nature of the assets underlying these instruments more palatable to investors, the loan bundles are layered in 'tranches,' with each tranch having a different bond-rating. The 'senior' tranch has the highest rating, sometimes even receiving investment-grade status, and investors in this tranch, in theory, have 'preferred' status in terms of income disbursements. Investors in lower tranches lack preferred status, and only receive income if there are sufficient funds, their 'reward' for this subjugation being a higher rate of return. See Id. Indeed, bond insurers, such as MBIA and Ambac, who have traditionally been monoline insurers guaranteeing only municipal bonds, have now become involved in insuring mortgage-backed securities. See Vikas Bajaj, Big Bond Insurer Discovers That Layers of Risk Do Not Create a Cushion, N.Y. Times, Dec. 21, 2007, available at www.nytimes.com/2007/12/21/business/21bond.html?emc=eta1. These insurers are not immune from the subprime fallout. The SEC has initiated investigations into bond insurers related to their role in the subprime crisis. See Paritosh Bansal, SEC Eyes Bond Insurers in Subprime Probes, Reuters, March 6, 2008, available at www.reuters.com/article/email/idUSN0561896720080306.

It is important to understand that all of the tranches in a mortgage-backed security are underlain by the same bundled subprime debt, and a tranch's greater or lesser bond rating is a function only of the rules governing disbursements to investors, not of the quality of the underlying collateral. The collapse in the market for these securities, and resulting write-downs by investing institutions, has created a whole new category of prospective parties in the subprime litigation universe ' specifically, investors and pensioners asserting negligence, failure to follow proper investment guidelines, and claims of misrepresentation against the Wall Street firms that underwrote the mortgage-backed securities and even the credit-rating agencies that classified some of those instruments as investment grade. See Sabry & Schopflocher, supra, at 12, 13.

An Overview of D&O Coverage

The foregoing is simply a representative sample of the types of claims that have resulted and/or may result from the subprime mortgage crisis. As noted previously, due to the nature and complexity of subprime transactions, the universe of potential claims defies comprehensive identification. Plaintiffs in some subprime cases are likely to be defendants in others. When faced with a subprime suit, however, subprime defendants presumably will request that their insurers defend and indemnify them in connection with those matters. Depending upon the allegations stated in the complaint, it is anticipated that subprime defendants will most often look to their D&O policies for coverage, although other policies, such as errors and omissions policies or certain specialty policies, may also be implicated.

In essence, D&O coverage may be viewed as a variation of professional liability coverage aimed at protecting directors and officers against liabilities associated with their corporate responsibilities. Olson & Hatch, supra, '12:1. D&O polices typically provide two, or in some cases three, types or 'sides' of coverage. Side A coverage provides indemnification to the directors and officers of a corporation when the corporation does not or cannot do so (sometimes because the corporation's charter or bylaws prohibit it.) See William E. Knepper & Dan A. Bailey, 2 Liability of Corporate Officers & Directors '23.02 (7th ed. 2006). Side B coverage provides reimbursement to the corporation that has indemnified its directors and officers, and thus is an indirect form of D&O coverage. Id. Side C coverage, also known as 'entity coverage,' is insurance coverage for the direct liabilities of the corporation itself. See Id.; Olson & Hatch, supra, '12:5. Entity coverage is typically limited in extent and is not available in every D&O policy; i.e., an insured must often purchase it separately, and thus pay an extra premium for the coverage. Any of these coverages might be subject to individualized terms, conditions, and exclusions. Moreover, separate limits, sublimits, retentions, and co-insurance requirements may also apply.

In general, D&O policies do not contain the usual 'duty to defend' requirement found in most comprehensive general liability policies. See Pan Pac. Retail Props., Inc. v. Gulf Ins. Co., 471 F.3d 961, 970 (9th Cir. 2006). D&O insurers, however, frequently retain the right to associate in the defense of the insured at their option. The insured, therefore, must often retain its own counsel, although sometimes the policy requires the insured to choose from a panel of insurer-approved counsel. Most frequently, defense and indemnity expenses are both included under the broad definition of 'Loss' and both serve to exhaust any applicable retentions and/or limits of liability.

Like most other types of liability policies, a preliminary step in analyzing coverage when a claim is presented under a D&O policy is to determine whether the broad coverages granted as part of Side A, B, and/or C are potentially implicated. Typically, to trigger coverage under a D&O policy, the insured must present a 'Claim' made against it under one or more of the coverages during the policy period, for a 'Wrongful Act' of the insured, which results in a 'Loss' to the insured. See generally Olson & Hatch, supra, ”12:6-12:7. The aforementioned terms are almost universally defined in an expansive manner. See Id. '12:7. The breadth of the definition of 'claim,' or a court's interpretation of that definition, may have serious implications, for example, when an insured cooperates in a government agency's investigation into its subprime-related activities. Commentators have noted, however, that the definition of 'claim' in recent years has sometimes been 'broadened by several additional and significant enhancements, including the addition of civil, criminal, administrative or regulatory investigations, as well as grand jury proceedings.' Id.

Similarly, 'Loss' with respect to individual insured directors and officers 'is generally defined as any amount for which the insured is legally liable and that arises out of a claim made against him for wrongful acts.' Id. '12:10. For side B coverage, loss 'may encompass any amount for which the corporation indemnifies its directors and officers for covered wrongful acts by such directors and officers.' Id. 'Loss' for side C 'entity' coverage is typically limited to a corporation's recovery 'for losses it incurs arising out of securities claims made against the corporation itself.' Id. One subprime area in which the definition of 'Loss' may become important is in actions for disgorgement under ”11 and 12 of the 1934 Securities and Exchange Act, regarding misstatements and omissions vis-'-vis a company's initial public offering of securities. In those cases, courts have held that disgorgement of profits gained at the expense of shareholders by virtue of misrepresentations or omissions that affect a security's price does not qualify as a 'loss,' but instead must be returned because they were 'wrongfully [taken] from the investing public.' See Conseco v. Nat'l Union Fire Ins. Co. of Pittsburgh, Pa., No. 49D130202CP000348, 2002 WL 31961447, *6-13 (Ind. Cir. Ct. Dec. 31, 2002); see also Reliance Group Holdings, Inc. v. Nat'l Union Fire Ins. Co. of Pittsburgh, Pa., 188 A.D.2d 47, 54-55 (N.Y. App. Div. 1993) (holding that restitution of profits wrongfully obtained through settlement did not constitute insurable 'loss' under D&O policy). Apart from the 'loss' definition, many D&O policies contain a separate exclusion barring coverage for restitutionary awards or the return of so-called 'ill-gotten gains' or illegal profits. See Alstrin v. St. Paul Mercury Ins. Co., 179 F. Supp. 2d 376, 398-401 (D. Del. 2002).

In that vein, after determining that the underlying conduct is potentially covered under Sides A, B, and/or C, it is also necessary to analyze whether coverage is excluded or otherwise limited or affected by policy exclusions, terms, and conditions, some of which are discussed infra. D&O policies typically contain dozens of exclusionary provisions and conditions to coverage. Policyholders, who many times do not review their D&O policies until a claim is presented, are often surprised by what may appear to be a veritable minefield of coverage limiting provisions. The surprise is often exacerbated by reservation of rights letters identifying innumerable caveats to coverage and/or denial letters identifying numerous unanticipated grounds for denial.

Next month's installment will address specific D&O coverage issues.

Brian J. Osias is a partner, and Craig W. Davis and Jason M. Alexander are associates at McCarter & English, LLP in Newark, NJ. They specialize in representing corporate policyholders in complex insurance disputes. The views expressed in this article do not necessarily reflect the position of their firm or its clients. This article is not intended to provide legal advice. Issues related to insurance coverage are fact specific, and their resolution will depend on the precise policy terms involved and the law governing the disputes, which varies from state to state.

Part One of a Two-Part Article

The specter of a subprime mortgage crisis has gone from a background murmur in the recently quieted real estate boom to attain official 'meltdown' status in the media, and the reverberations are being felt in all corners of the corporate and financial world. Recently, the city of Cleveland, OH, brought an action against 21 banks and other financial institutions, alleging that predatory lending practices related to subprime mortgages have led to more than 14,000 foreclosures in the city in the last two years, resulting in pandemic urban blight. See Christopher Maag, Cleveland Sues 21 Lenders over Subprime Mortgages, N.Y. Times, Jan. 12, 2008, available at www.nytimes.com/2008/01/12/us/12cleveland.html?_r=1&emc=eta1&oref=slogin. The Cleveland action was actually brought under public nuisance laws, and it names as defendants the financial institutions that securitized and sold the loans in the financial markets. Id.

In 2007, four Norwegian towns near the arctic circle were plunged into financial gloom when their substantial investments in mortgage-backed securities created by Citigroup lost more than half of their value as a result of the troubles in the United States mortgage and housing markets. See Julia Werdigier, Subprime Woes Hit Norwegian Brokerage, N.Y. Times, Nov. 29, 2007, available at www.nytimes.com/2007/11/29/business/worldbusiness/29bank.html?emc=eta1. Indeed, the crisis in the housing and mortgage markets is not confined to obscure villages and downtrodden cities. See Michael Jackson Late on Family's House Payments, cnn.com (Feb. 29, 2008), at www.cnn.com/2008/SHOWBIZ/Music/02/29/michael.jackson.ap/.

As the wave of litigation related to subprime defaults builds momentum, the people and institutions targeted by that litigation are looking to their insurers for reimbursement of the costs of defending those actions and any resulting liabilities. In particular, defendants in such actions are seeking, and will continue to seek, coverage under their directors and officers ('D&O') policies. Indeed, D&O insurers are likely to face unprecedented claims in connection with the subprime crisis. One insurance industry observer believes that 'subprime-linked payouts by providers of directors and officers insurance are expected to be higher than the payouts for any other single event in history.' See Mary Thomson, D&O Insurers Take Hit from Subprime Payouts, cnbc.com (Feb. 12, 2008), at www.cnbc.com/id/23130521.

There are bound to be insurance disputes associated with subprime issues given the vast exposure and number of claims facing D&O insurers. At this early stage, however, it is difficult to predict the coverage issues that will present themselves most frequently in connection with the subprime crisis. As with other liabilities, coverage litigation related to subprime liabilities is likely to lag behind the present wave of underlying claims. Moreover, the types of claims arising out of the subprime crisis are incredibly diverse, and any individualized coverage analysis must turn on the unique facts and circumstances surrounding a particular claim.

Recurring D&O issues, however, have arisen in connection with prior 'meltdowns,' such as the securities class actions and shareholder derivative suits brought in the wake of the 'savings and loan' scandal of the 1980s and 1990s ('S&L Scandal') and the more recent 'accounting irregularities' involving Enron and Arthur Andersen, among others. As one example, D&O Insurers attempted to mitigate losses related to the savings and loan scandal by adding a regulatory exclusion to their policies. A typical regulatory exclusion seeks to exclude coverage for claims by regulators of financial institutions, including the Federal Deposit Insurance Corporation and the Federal Savings & Loan Insurance Corporation. See John F. Olson & Josiah O. Hatch, III, Director & Officer Liability: Indemnification and Insurance '12:15 (2003). Interpretations of regulatory exclusions, however, have been mixed. Some courts have upheld them as written, while others have refused to apply them on public policy grounds. Id. Compare, e.g. , Fed. Deposit Ins. Corp. v. Aetna Cas. & Sur. Co. , 903 F.2d 1073, 1078 (6th Cir. 1990), with Am. Cas. Co. of Reading, Pa. v. Fed. Deposit Ins. Corp. , 677 F. Supp. 600, 604 (N.D. Iowa 1987). Similarly, it is possible that insurers will attempt to draft an exclusion aimed at limiting, or excepting from coverage D&O claims related to subprime liabilities, particularly if current losses continue to escalate.

In any event, whereas D&O coverage in the subprime context remains largely untested, there is a body of case law interpreting D&O policies in analogous circumstances. Some of the issues that have presented themselves prominently in prior cases include:

• Whether coverage was barred by the policyholder's purported failure to comply with the D&O policy's notice requirements;
• Whether the conduct at issue was ultra vires and thus outside of the D&O policy's coverage grant;
• Whether coverage was defeated by exclusionary provisions concerning fraudulent, criminal, or illegal conduct;
• Whether coverage was excluded by the so called 'insured v. insured' exclusion, which limits coverage for claims brought by one insured against any other insured under the D&O policy; and
• Whether policy rescission was warranted based upon inaccuracies in the policy application.

Accordingly, it is not unreasonable to speculate that these issues may also become prominent in connection with the present subprime meltdown.

Background: Roots of the Crisis and the Resulting Litigation

The subprime mortgage crisis has many facets, which are reflected by the quantity and variety of lawsuits that have arisen in recent months. Simply put, the crisis resulted from defaults on 'bad' home loans to risky borrowers characterized as 'subprime.' As compared with 'prime' borrowers, subprime borrowers are more likely to default on their loans due to poor credit history, low income coupled with high consumer debt, and/or other risk factors. See Faten Sabry & Dr. Thomas Schopflocher, The Subprime Meltdown: A Primer 2 (NERA Economic Consulting June 21, 2007), available at http://www.nera.com/.

Accordingly, subprime borrowers must pay a premium on their loans in the form of a higher interest rate. The interest rate is either fixed or adjustable, and very often (and problematically) a combination of both. Subprime borrowers are often provided an introductory, lower rate ' sometimes referred to as a 'teaser' rate ' followed after several months by a rate that adjusts (typically upward) on a regular basis. In addition, because subprime borrowers often have a low income to debt ratio, and consequently are less likely to have substantial savings, they tend to make smaller down payments.

The result of the aforementioned arrangement is a high loan-to-value ratio ' sometimes as high as 100% ' that provides less of an 'equity cushion' in the event of a slowdown or downturn in the market appreciation of residential real estate. This equity deficit gives the borrower no alternative but default (instead of refinancing) when a market slowdown occurs and the borrower cannot make his mortgage payments. The situation is often compounded when the borrower's monthly payment increases under the terms of an adjustable rate mortgage. It also can deprive the lender of the value of its collateral when it is forced to foreclose. See Id.

Subprime loans are not new. They have historically represented 10% to 12% of the mortgage market, but their prevalence in the recent market was unprecedented. See Victoria Wagner, A Primer for the Subprime Problem, Business Week, March 13, 2007, available at www.businessweek.com/investor/content/mar2007/pi20070313_837773.htm. At 20% (and a staggering 40% of the adjustable rate and interest-only loan market), subprime lending rates have far exceeded their historically normal levels. See Id. Accordingly, the recent housing bust and the ensuing fallout of defaults and foreclosures have led to lawsuits against lending institutions, underwriters, and mortgage brokers by aggrieved borrowers alleging predatory lending practices, misrepresentation, disclosure violations, fraud, and unfair trade practices. Additionally, subprime plaintiffs have alleged violation of consumer protection laws based upon overly complex and/or poorly explained mortgage instruments as a result of 'payment shock' after the expiration of the 'teaser' rates. See Sabry & Schopflocher, supra, at 11 & 13 (Fig. 8). To the extent that federal and state 'holder rules' make them liable, the present holders of the loans, in addition to the loans' originators, could be targeted by these lawsuits, as might assignees and even investment banks, that arguably ratified, facilitated, or acquiesced in the lenders' conduct in the process of financing or securitizing the loans. These consumer-debtor suits may come in the form of a class action, see, e.g., Plumbers' Union Local No. 12 Pension Fund, Individually and on Behalf of All Others Similarly Situated v. Swiss Reinsurance Co. et al., No. 08 CV 10958 (S.D.N.Y. Feb. 27, 2008) (Complaint), and may, in turn, spawn indemnification actions as investment banks assert indemnity claims against lenders, who in turn will seek indemnification from the mortgage brokers who marketed and sold the loans to consumers.

Other types of lawsuits implicating subprime lending practices have already been filed or are expected to be filed. For instance, as banks and lending institutions have suffered the financial consequences of subprime loans gone bad, shareholders have brought class actions for fraud against banks and their directors and officers under federal securities laws for their questionable valuations, alleged financial misrepresentations and omissions, and poor underwriting standards. See Sabry & Schopflocher, supra, at 12, 13 (Fig. 8); Foreclosure Fallout: Subprime Lending Crisis Adds to Banks' Insurance Headaches, ABA Banking Journal, Jan. 2008, at 36. Similarly, lending institution employees have sued their employers ' and their directors and officers ' under the federal Employee Retirement Income Security Act ('ERISA') when their retirement savings, invested in company stock, have all but disappeared. Id. at 36, 38.

The landscape receives an added layer of complexity because of the practice of securitization. Theoretically, securitization of subprime debt increases credit availability and liquidity in the mortgage market. See Sabry & Schopflocher, supra, at 4-8. In short, the originator of a subprime loan often seeks to sell the loan to a trust, which underwrites debt securities by pooling the loans into bonds called mortgage-backed securities. The trust sells the securities to an underwriter or investment bank, which in turn sells the securities to investors ' typically, mutual funds, hedge funds, insurance companies and/or pension plans. To make the subprime nature of the assets underlying these instruments more palatable to investors, the loan bundles are layered in 'tranches,' with each tranch having a different bond-rating. The 'senior' tranch has the highest rating, sometimes even receiving investment-grade status, and investors in this tranch, in theory, have 'preferred' status in terms of income disbursements. Investors in lower tranches lack preferred status, and only receive income if there are sufficient funds, their 'reward' for this subjugation being a higher rate of return. See Id. Indeed, bond insurers, such as MBIA and Ambac, who have traditionally been monoline insurers guaranteeing only municipal bonds, have now become involved in insuring mortgage-backed securities. See Vikas Bajaj, Big Bond Insurer Discovers That Layers of Risk Do Not Create a Cushion, N.Y. Times, Dec. 21, 2007, available at www.nytimes.com/2007/12/21/business/21bond.html?emc=eta1. These insurers are not immune from the subprime fallout. The SEC has initiated investigations into bond insurers related to their role in the subprime crisis. See Paritosh Bansal, SEC Eyes Bond Insurers in Subprime Probes, Reuters, March 6, 2008, available at www.reuters.com/article/email/idUSN0561896720080306.

It is important to understand that all of the tranches in a mortgage-backed security are underlain by the same bundled subprime debt, and a tranch's greater or lesser bond rating is a function only of the rules governing disbursements to investors, not of the quality of the underlying collateral. The collapse in the market for these securities, and resulting write-downs by investing institutions, has created a whole new category of prospective parties in the subprime litigation universe ' specifically, investors and pensioners asserting negligence, failure to follow proper investment guidelines, and claims of misrepresentation against the Wall Street firms that underwrote the mortgage-backed securities and even the credit-rating agencies that classified some of those instruments as investment grade. See Sabry & Schopflocher, supra, at 12, 13.

An Overview of D&O Coverage

The foregoing is simply a representative sample of the types of claims that have resulted and/or may result from the subprime mortgage crisis. As noted previously, due to the nature and complexity of subprime transactions, the universe of potential claims defies comprehensive identification. Plaintiffs in some subprime cases are likely to be defendants in others. When faced with a subprime suit, however, subprime defendants presumably will request that their insurers defend and indemnify them in connection with those matters. Depending upon the allegations stated in the complaint, it is anticipated that subprime defendants will most often look to their D&O policies for coverage, although other policies, such as errors and omissions policies or certain specialty policies, may also be implicated.

In essence, D&O coverage may be viewed as a variation of professional liability coverage aimed at protecting directors and officers against liabilities associated with their corporate responsibilities. Olson & Hatch, supra, '12:1. D&O polices typically provide two, or in some cases three, types or 'sides' of coverage. Side A coverage provides indemnification to the directors and officers of a corporation when the corporation does not or cannot do so (sometimes because the corporation's charter or bylaws prohibit it.) See William E. Knepper & Dan A. Bailey, 2 Liability of Corporate Officers & Directors '23.02 (7th ed. 2006). Side B coverage provides reimbursement to the corporation that has indemnified its directors and officers, and thus is an indirect form of D&O coverage. Id. Side C coverage, also known as 'entity coverage,' is insurance coverage for the direct liabilities of the corporation itself. See Id.; Olson & Hatch, supra, '12:5. Entity coverage is typically limited in extent and is not available in every D&O policy; i.e., an insured must often purchase it separately, and thus pay an extra premium for the coverage. Any of these coverages might be subject to individualized terms, conditions, and exclusions. Moreover, separate limits, sublimits, retentions, and co-insurance requirements may also apply.

In general, D&O policies do not contain the usual 'duty to defend' requirement found in most comprehensive general liability policies. See Pan Pac. Retail Props., Inc. v. Gulf Ins. Co. , 471 F.3d 961, 970 (9th Cir. 2006). D&O insurers, however, frequently retain the right to associate in the defense of the insured at their option. The insured, therefore, must often retain its own counsel, although sometimes the policy requires the insured to choose from a panel of insurer-approved counsel. Most frequently, defense and indemnity expenses are both included under the broad definition of 'Loss' and both serve to exhaust any applicable retentions and/or limits of liability.

Like most other types of liability policies, a preliminary step in analyzing coverage when a claim is presented under a D&O policy is to determine whether the broad coverages granted as part of Side A, B, and/or C are potentially implicated. Typically, to trigger coverage under a D&O policy, the insured must present a 'Claim' made against it under one or more of the coverages during the policy period, for a 'Wrongful Act' of the insured, which results in a 'Loss' to the insured. See generally Olson & Hatch, supra, ”12:6-12:7. The aforementioned terms are almost universally defined in an expansive manner. See Id. '12:7. The breadth of the definition of 'claim,' or a court's interpretation of that definition, may have serious implications, for example, when an insured cooperates in a government agency's investigation into its subprime-related activities. Commentators have noted, however, that the definition of 'claim' in recent years has sometimes been 'broadened by several additional and significant enhancements, including the addition of civil, criminal, administrative or regulatory investigations, as well as grand jury proceedings.' Id.

Similarly, 'Loss' with respect to individual insured directors and officers 'is generally defined as any amount for which the insured is legally liable and that arises out of a claim made against him for wrongful acts.' Id. '12:10. For side B coverage, loss 'may encompass any amount for which the corporation indemnifies its directors and officers for covered wrongful acts by such directors and officers.' Id. 'Loss' for side C 'entity' coverage is typically limited to a corporation's recovery 'for losses it incurs arising out of securities claims made against the corporation itself.' Id. One subprime area in which the definition of 'Loss' may become important is in actions for disgorgement under ”11 and 12 of the 1934 Securities and Exchange Act, regarding misstatements and omissions vis-'-vis a company's initial public offering of securities. In those cases, courts have held that disgorgement of profits gained at the expense of shareholders by virtue of misrepresentations or omissions that affect a security's price does not qualify as a 'loss,' but instead must be returned because they were 'wrongfully [taken] from the investing public.' See Conseco v. Nat'l Union Fire Ins. Co. of Pittsburgh, Pa., No. 49D130202CP000348, 2002 WL 31961447, *6-13 (Ind. Cir. Ct. Dec. 31, 2002); see also Reliance Group Holdings, Inc. v. Nat'l Union Fire Ins. Co. of Pittsburgh, Pa. , 188 A.D.2d 47, 54-55 (N.Y. App. Div. 1993) (holding that restitution of profits wrongfully obtained through settlement did not constitute insurable 'loss' under D&O policy). Apart from the 'loss' definition, many D&O policies contain a separate exclusion barring coverage for restitutionary awards or the return of so-called 'ill-gotten gains' or illegal profits. See Alstrin v. St. Paul Mercury Ins. Co. , 179 F. Supp. 2d 376, 398-401 (D. Del. 2002).

In that vein, after determining that the underlying conduct is potentially covered under Sides A, B, and/or C, it is also necessary to analyze whether coverage is excluded or otherwise limited or affected by policy exclusions, terms, and conditions, some of which are discussed infra. D&O policies typically contain dozens of exclusionary provisions and conditions to coverage. Policyholders, who many times do not review their D&O policies until a claim is presented, are often surprised by what may appear to be a veritable minefield of coverage limiting provisions. The surprise is often exacerbated by reservation of rights letters identifying innumerable caveats to coverage and/or denial letters identifying numerous unanticipated grounds for denial.

Next month's installment will address specific D&O coverage issues.

Brian J. Osias is a partner, and Craig W. Davis and Jason M. Alexander are associates at McCarter & English, LLP in Newark, NJ. They specialize in representing corporate policyholders in complex insurance disputes. The views expressed in this article do not necessarily reflect the position of their firm or its clients. This article is not intended to provide legal advice. Issues related to insurance coverage are fact specific, and their resolution will depend on the precise policy terms involved and the law governing the disputes, which varies from state to state.