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

A defendant facing a subprime action and/or an insured that is the actual or potential target of a government investigation arising out of the subprime crisis should immediately notify its insurers under the notice provisions contained in their policies. Although not unique to D&O insurance, the issue of whether an insured gives timely notice will likely be one of the first, if not the first, issue analyzed from the insurers' perspective in any subprime claim.

The issue of notice is particularly important in D&O policies because such policies are almost always written on a 'claims-made' basis, as opposed to an 'occurrence' basis. Specifically, most D&O polices require that notice of claims be given 'as soon as practicable' and usually during the policy period, or alternatively within some short time period after the policy expires ' often referred to as the 'Discovery Period.' See 2 Knepper & Bailey, supra, '24.09. This 'extended reporting period' is usually 30 to 90 days. Id. Most courts have interpreted the phrase 'as soon as practicable' to mean 'within a reasonable time' under the facts and circumstances particular to the inquiry. See e.g., Argent Fin. Group Inc. v. Fid. & Deposit Co. of Md., No. 3:04CV02323, 2006 WL 1793609, *3 (W.D. La. June 28, 2006). Some D&O insurance is written on a 'claims-made-and-reported' basis. This arrangement is even more restrictive, requiring that both the claim against the insured and the notice of that claim to the insurer be provided during the policy period. Such policies, however, often give the insured the option of purchasing a 'Discovery Period' ' sometimes referred to as a 'tail' ' for the reporting of claims.

To ameliorate the harshness of strict notice requirements, many D&O policies allow insureds to provide early notice of circumstances that may, in the future, result in a potential claim. Such provisions in effect provide extended coverage past the policy period 'where 'facts and circumstances' that might give rise to a claim are known, but no 'claim' has been asserted against the insured.' In re Ambassador Group, Inc. Litig., 830 F. Supp. 147, 157 (E.D.N.Y. 1993).

In most jurisdictions (New York being the most notable exception), insurers may not base a refusal of 'occurrence based' insurance coverage on grounds of late notice unless they can show prejudice resulting from the timing of the notice. See The Argo Corp. v. Greater New York Mutual Ins. Co., 827 N.E.2d 762, 765 (N.Y. 2005); see, also, Salt Lake Toyota Dealers Assoc. v. St. Paul Mercury Ins. Co., No. 2:05-CV-497 TS, 2006 WL 1547996, *4, (D. Utah June 6, 2006). The majority of jurisdictions, however, have refused to apply this notice-prejudice rule to claims-made policies, reasoning that allowing notice beyond the time defined in the policy provides the insured with an 'unbargained-for extension of the policy period.' See Id. n.39 (collecting cases from various jurisdictions). D&O insurers, therefore, in most instances need not show prejudice to sustain a disclaimer of coverage based on late notice.

Activities That Are Potentially Ultra Vires

As noted previously, under Side A coverage, a typical D&O policy provides for payment of a 'Loss … arising from' a claim made against the director or officer for an alleged 'Wrongful Act.' See Olson & Hatch, supra, at App. 12-1-2. Limitations in the definition of 'wrongful act,' however, may be key considerations with respect to D&O subprime claims. Specifically, a typical definition of 'Wrongful Act' may provide:

'Wrongful Act' means any breach of duty, neglect, error, misstatement, misleading statement, omission or act by the Directors or Officers of the Company in their respective capacities as such, or any matter claimed against them solely by reason of their status as Directors or Officers of the Company.

Id. at App. 12-1-3 (quoting AIG/ National Union policy); see also Id. at App. 12-2-14 (defining 'Wrongful Act' as 'any error, misstatement, misleading statement, act, omission, neglect, or breach of duty committed, attempted, or allegedly committed or attempted, by an Insured Person, individually or otherwise, in his Insured Capacity, or any matter claimed against him solely by reason of his serving in such Insured Capacity' (quoting Chubb policy form)).

By its terms, this is a broad coverage provision, applying to the enumerated wrongful acts or to any other claim against a director or officer 'solely by reason of' his or her status as an officer or director. See McAninch v. Wintermute, 491 F.3d 759, 769 (8th Cir. 2007). Although no longer typical, policyholders should be aware that some older policies restricted the definition of wrongful acts to acts of negligence. See Olson & Hatch, supra, '12:9; 2 Knepper & Bailey, supra, '24.07.

On the other hand, a potentially coverage-narrowing aspect of this definition is the requirement that the wrongful act be committed by a director or officer in his capacity as a director or officer. Thus, there will likely not be coverage for a director or officer for actions that are either ultra vires and/or in some other capacity (for example, that of an owner, a lawyer, trustee, partner, employee, or shareholder). See Olson & Hatch, supra, '12:9; 2 Knepper & Bailey, supra, '24.07; see also Olson v. Fed. Ins. Co., 219 Cal. App. 3d 252, 263-64 (1990) (holding that acts of director were committed in capacity of shareholder, not director, and thus not covered as 'wrongful acts' under D&O policy). Courts, however, have not generally restricted coverage when a director or officer merely functions in more than one capacity within a corporation (for example director and owner, or director and shareholder), unless the insurer wishing to disclaim coverage can show that the person's dual capacity somehow relates to the alleged wrongful conduct for which coverage is sought. See McAninch, 491 F.3d at 772.

Therefore, when an individual assumes multiple roles within a corporation, including that of an officer or director, it may be important for policyholders to consider those roles separately when considering what types of insurance coverage to procure. Since a D&O policy may not cover liabilities associated with acts committed in some other capacity, other types of coverage (for example, professional liability coverage), if available, should be considered to provide seamless, or at least fuller coverage for corporate executives who wear more than one hat.

Similarly, there will generally not be coverage for the actions of a director of the insured entity when those actions are performed as a member of the board of another (non-subsidiary) entity, see Bowie v. Home Ins. Co., 923 F.2d 705, 709 & n.4 (9th Cir. 1991); see also Olson, 219 Cal. App. at 260-61 (holding that acts committed by individual as owner of related company were not 'wrongful' acts of director of company named in D&O policy), although 'outside directorship' coverage can be purchased by separate endorsement. Olson & Hatch, supra, '12:9. Also, it may be important to review the company's bylaws to ascertain which executives and managers are considered 'officers' of the company, and thus whose wrongful acts are covered under the policy (or any policy endorsements).

Exclusions for Dishonest, Criminal, or Fraudulent Acts

D&O policies typically contain exclusions for dishonest, criminal, and/or fraudulent acts ('dishonesty exclusions'), which have been widely invoked in the past by insurers wishing to disclaim coverage. In particular, these exclusions factored prominently into D&O claims arising out of the S&L Scandal, and there is little reason to suspect that the exclusion will not be in the forefront of coverage disputes over subprime-related claims. The dishonesty exclusions take on various forms, some broadly excluding 'dishonest' acts, others also encompassing 'fraudulent,' and/or 'criminal' acts, and often also requiring that the excluded conduct be 'deliberate' or even 'deliberate and active.' See 2 Knepper & Bailey, supra, '25:03. The essence of all of these variations is the exclusion of coverage for certain conduct ' lacking probity ' for which insurance coverage would be inappropriate as a matter of public policy. See Olson & Hatch, supra, '12:13. One court chastised an insurer that attempted to apply the fraud exclusion to bar coverage for securities fraud, even though the policy's entity-side coverage expressly covered 'Securities Claims.' See Alstrin, 179 F. Supp. at 395-98. The court rejected the attempt to construe the entity coverage as applying only to unintentional conduct, '[p]articularly[ ] in a D&O insurance policy, where securities fraud claims are among the most common claims.' Id. at 398. The court held that the insured's reasonable expectations of coverage for 'Securities Claims' could not be eviscerated by the exclusion. Id. at 397-98. The scienter requirement to the dishonesty exclusions will generally except strictly negligent misrepresentations from the reach of the exclusion. See Int'l Surplus Lines Ins. Co. v. Univ. of Wyo. Research Corp., 850 F. Supp. 1509, 1525 (D. Wyo. 1994); see also Continental Cas. Co. v. Tierney, No. 89-0679-CV-W-6, 1991 WL 207398 (W.D. Mo. July 2, 1991).

In general, a crucial aspect of the dishonesty exclusions is that they do not take effect upon mere allegations of dishonesty or fraud ' which would, in many cases, eviscerate the D&O coverage. Rather, the exclusions typically require either dishonesty 'in fact' or an actual adjudication of dishonesty, although some policy forms do not contain such an express qualification. Compare Alstrin, 179 F. Supp. 2d at 395 (excluding 'claims 'arising out of, based upon or attributable to the committing in fact of any criminal or deliberate fraud”), with In re Enron Corp. Secs. Derivative & 'ERISA' Litig. (Newby v. Enron Corp.), 391 F. Supp. 2d 541, 570 (S.D. Tex. 2005), and Int'l Surplus Lines v. Univ. of Wyo. Research Corp., 850 F. Supp. at 1524 (requiring a judgment or 'final adjudication' of fraud).

In International Surplus Lines, the court concluded that a default judgment satisfied the exclusion's requirement of a 'final adjudication.' 850 F. Supp. at 1524. Cf. First Nat'l Bank Holding Co. v. Fid. & Deposit Co. of Md., 885 F. Supp. 1533, 1537 (N.D. Fla. 1995) (holding that guilty plea resulting in a criminal conviction constitutes a 'final adjudication' for purposes of exclusion). As noted, some D&O policies do not contain this requirement, see Olson & Hatch, supra, '12:13, so it is important that a prospective D&O policyholder be sure that its policy does not exclude coverage on mere allegations of dishonesty. Thus, for example, when the directors or officers of an investment bank are sued under federal securities laws for their participation, or acquiescence, in the creation, marketing, or securitization of subprime debt (as for example, in the Plumbers' Union Complaint, supra, in which plaintiffs allege that Swiss Reinsurance Company violated the 1934 Securities and Exchange Act by failing to disclose that it had written certain subprime-based derivatives (default swaps) that allegedly 'exposed the Company to great financial risk') the mere allegation of fraud inherent in the claim or charge probably will not in most cases act as a bar to coverage until such fraud has been adjudicated or otherwise rendered a fait accompli.

Another important aspect of the dishonesty exclusion of which a prospective policyholder should be cognizant is whether the dishonest acts of individuals are severable vis-'-vis other directors and officers; in other words, whether dishonest acts of one insured are necessarily imputed to all insureds. Obviously, the D&O shopper should seek coverage for which the dishonesty exclusion is severable as among insureds. Outcomes and arguments, however, may vary depending inter alia on specific policy language and the factual circumstances surrounding a particular claim.

An important issue for a D&O policyholder facing a subprime lawsuit raising claims of fraud or dishonesty (for example, securities fraud) will be whether the insured's defense expenses are reimbursable under the policy. In the high-profile litigation involving the directors and officers of Enron Corporation, a federal district court had an opportunity to address this issue. The issue in Newby v. Enron Corp. was whether the insureds, directors, and officers of Enron were entitled to ongoing payment of defense costs in criminal proceedings against them. 391 F. Supp. 2d at 557-58. The policy at issue excluded coverage:

for specific claims brought about or contributed to by the dishonest, fraudulent, criminal or malicious act or omission of [a] DIRECTOR or OFFICER if a final adjudication establishes that acts of active and deliberate dishonesty were committed or attempted with actual dishonest purpose and intent and were material to the cause of action so adjudicated. Id. at 570.

A dishonest or fraudulent act need not be criminal to fall within the exclusion. See Int'l Surplus Lines v. Univ. of Wyo. Research Corp., 850 F. Supp. at 1523. The court found the policy as a whole to be ambiguous and interpreted the exclusion in favor of the insureds, holding that their criminal defense costs were covered, 'but only where the insured is ultimately found not guilty of having committed or attempted to commit acts of dishonesty, fraud, or criminality.' 391 F. Supp. 2d at 573. If the insureds were ultimately convicted of an act of fraud or dishonesty, they would be required to pay back the fronted defense costs to the insurer. Id. at 575.

Perhaps even more significantly, the Newby court followed the majority of courts in also holding that where there is a potentially applicable dishonesty exclusion, an insurer must pay its insured's defense costs as they are incurred. Id. at 573. Considering the ubiquity of fraud and dishonesty allegations in the types of claims to which corporate officers and directors are subject, the court held that requiring an insured to advance his own defense costs until there had been a favorable disposition regarding fraud or dishonesty 'could bring financial ruin upon a director or officer.' Id. at 574. The Newby court, however, also noted that some courts had rejected imposing a duty of ongoing reimbursement of defense costs on insurers. Id. n.40. Some of those cases involved an 'option clause' that explicitly gave the insurer the option (not a duty) to pay defense costs on an advance basis. Id. (citing Zaborac v. Am. Cas. Co. of Reading, Pa., 663 F. Supp. 330 (C.D. Ill. 1987); Luther v. Fid. & Deposit Co., 679 F. Supp. 1092 (S.D. Fla. 1986)).

But at least one court holding that a D&O insurer has no duty to advance defense costs as incurred acknowledged that the policy under consideration did not contain an option clause. Kenai Corp. v. Nat'l Union Fire Ins. Co., 136 B.R. 59, 63-64 (S.D.N.Y. 1992) (citing cases holding that insurer has no duty to advance defense costs, acknowledging that policy before it did not contain 'option clause,' and holding that 'the plain meaning of the terms of the D&O policy at issue here' does not require the insurer to advance defense costs), cited in Newby, 391 F. Supp. at 574 n.40. That court reasoned that requiring an insurer to advance defense costs even for claims that would turn out not to be covered under the policy would prejudice insurers, even if the insured was required to reimburse the insurer for those uncovered defense costs. Kenai Corp., 136 B.R. at 64.

The Insured vs. Insured Exclusion

The insured versus insured exclusion seeks to bar coverage for suits between the corporate policyholder and its directors and officers. Fid. & Deposit Co. of Md. v. Zandstra, 756 F. Supp. 429, 432 (N.D. Cal. 1990). The exclusion first arose in the early 1980s when financial institutions, in an attempt to access their D&O insurance coverage, sued their own directors and officers for loss resulting from underperforming loans. Thus, the fundamental purpose of the exclusion was to prevent collusive lawsuits. See Olson & Hatch, supra, '12:14. Additionally, a host of new issues may arise out of the exclusion based upon the expanded definition of 'Insured' under many current D&O policy forms, which, in addition to officers and directors, may include employees or trustees of the corporation, among other individuals. It is also important to note that the corporation itself may also be included as an 'Insured' under the D&O policy, particularly if Side C 'entity' coverage is purchased.

Some courts have upheld the insured versus insured exclusions as clear and unambiguous, even while recognizing that the underlying purpose of the exclusion, i.e., to avoid collusive suits, is not necessarily furthered by its application. See, e.g., Sphinx Int'l, Inc. v. Nat'l Union Fire Ins. Co. of Pittsburgh, Pa., 226 F. Supp. 2d 1326, 1337 (M.D. Fla. 2002) (holding that when former officer and director was involved in underlying securities class action, 'the lack of collusion in the underlying suit does not bar the application of the insured v. insured exclusion … and the exclusion covers the claims of all the plaintiffs in the instant securities suit.'); see also Level 3 Communication, Inc. v. Fed. Ins. Co., 168 F.2d 956 (7th Cir. 1999). Accordingly, some D&O policies now carve out shareholders' derivative suits from the insured versus insured exclusion, expressly preserving coverage for such suits. See Olson & Hatch, supra, '12:14; see also, Zandstra, 756 F. Supp. 429. The policy in Zandstra was typical in that it contained an exception to the insured versus insured exclusion for a 'shareholders' derivative action by a shareholder of the [insured], when such shareholder is not a Director or Officer of the [insured].' Id. at 430. Furthermore, the court noted that this exception to the exclusion 'demonstrates [the insurer] intended to place itself on the risk for actions against the directors and officers based upon allegations of mismanagement, waste, fraud, or abuse of [the insured corporation].' Id. at 431. Other policy forms, however, do not provide for any such carve outs.

In addition to shareholder derivative actions, other types of subprime lawsuits may implicate the insured versus insured exclusion, including, for example, ERISA suits by employees and/or pensioners or bankruptcy trustee suits against former directors and officers ' particularly where the definition of 'Insured' includes employees and trustees as noted above. See Frederic Giordano and Sherilyn Pastor, What Bank Directors and Officers Should Know About D&O Insurance, Community Banker (Nov. 2007) ('Some courts have found that the bankruptcy trustee steps into the company's shoes such that the exclusion applies. Other courts have declined to apply the exclusion in those circumstances because such suits are not collusive. Many insurers have narrowed the exclusionary language so that it does not apply to directors and officers who have not held their position for a set number of years or to claims brought by a bankruptcy trustee.').

Rescission

It is estimated that 130 companies have taken a total $257 billion in write-downs related to the subprime crisis. Thomson, supra. These accounting revisions portend a potential ground on which an insurer might seek to deny coverage ' insurers may argue for rescission of the policy based on alleged misrepresentations in the insurance application. Specifically, an insurer might argue that it would not have written the policy as it did, or would have charged a higher premium, or would not have issued the policy at all, had the 'true' financial condition of the insured been known from the outset.

Restatements of a company's financial condition, however, are not uncommon and not always indicative of prior misstatements or omissions. Rather, the restatements are far more likely to indicate a legitimate change in accounting practices or a revision based on unforeseen circumstances and events. See Josephine H. Hicks, D&O Coverage in the Post-Enron World, Coverage (Dec. 2002). Thus, depending on the jurisdiction, in order to prevail on a rescission claim, an insurer most likely must demonstrate that the representation was not only false, but also that it was material and relied on by the insurer, or that it was intentional, or that it was either material or fraudulent. See Id. The materiality requirement is often central to the issue. If an insurer can show that prior misstatements significantly influenced its underwriting decisions, it may have a stronger rescission claim. See Id.

Policy language is often the key in determining the scope of an insurer's rescission rights. In Federal Insurance Co. v. Homestore, Inc., 144 Fed. Appx. 641 (9th Cir. 2005), for example, the court held that California public policy did not bar insurers from rescinding a D&O policy when the company's chief financial officer, and signer of the insurance applications, made material misrepresentations in the company's financial statement. After reviewing that statement, Homestore's board of directors issued a 'restatement' of the company's financial condition, revealing a prior significant overstatement of advertising revenues. Securities claims and shareholders derivative suits followed. Id. at 645.

The primary D&O policy provided that statements contained in the application, as well as any materials submitted with it, were deemed part of the policy. Id. The policy also provided that if the information in the application or materials submitted contained material misrepresentations, then:

no coverage shall be afforded … for any Director or Officer who did not sign the Application but who knew on the inception date of this Policy the facts that were so misrepresented, and this Policy in its entirety shall be void and of no effect whatsoever if such misrepresentation were known to be untrue on the inception date of the Policy by one or more of the individuals who signed the Application. Id.

The Ninth Circuit, affirming the District Court, held that the policy 'anticipates rescinding coverage to all Insureds without knowledge of misrepresentations, based upon material misrepresentations known to a signer.' Id. at 647; see also Shapiro v. Am. Home Assurance Co., 584 F. Supp. 1245, 1252 (D. Mass. 1984) (imputing misrepresentation to 'innocent' insureds because statements in application 'misrepresented the risk incurred in insuring all those covered by the policy'); Bird v. Penn Central Co., 334 F. Supp. 255 (E.D. Pa. 1971) (imputing misrepresentation to all insureds based on theories of agency and ratification).

Similarly, a restatement of earnings was the basis for an insurer's attempt to rescind a D&O policy, based on alleged misstatements and omissions in the renewal application, in Executive Risk Indemnity, Inc. v. AFC Enterprises, Inc. 510 F. Supp. 2d 1308 (N.D. Ga. 2007). The restatement spawned a flurry of securities class actions and shareholder derivative suits against the company. Id. at 1317-18. The policy at issue limited the insurer's ability to rescind based on a misrepresentation in the application only as to those persons who knowingly made material misrepresentations and who signed the application. Id. at 1324-25. Because the individuals who signed the application provided information only 'to the best of [their] knowledge and belief,' and because they also credibly testified that they believed the pre-restatement disclosures were accurate, the court rejected the insurer's rescission claim. Id. at 1325-28.

In any event, applications for D&O insurance include questions about whether the insured has any knowledge of actions or omissions that might give rise to a claim under the policy. In the midst of the subprime crisis, it is vitally important that prospective D&O policyholders, and those renewing existing D&O coverage, answer these questions in a forthright manner at risk of losing the D&O coverage entirely. Indeed, the D&O application should be prepared with extreme care and precision.

Conclusion

The crisis affecting the subprime mortgage market has already implicated D&O insurance providers to an unprecedented degree, and it will undoubtedly continue to do so. And while the present subprime turmoil is of recent vintage, many of the coverage issues that are likely to arise in the wake of the crisis are not new. As potential liabilities related to corporations' involvement in the sale, underwriting, marketing, and/or securitization of subprime mortgages continue to be hashed out in the courts, policyholders and their insurers will not lose sight of where the money to fund the defense and indemnity of these suits will come from. If past financial disasters are any indication, policyholders and insurers will fight vigorously to protect their interests. This article has addressed some of the more prominent coverage issues likely to arise in the subprime context, and has provided some guidance as to how those issues might play out when the second (and perhaps inevitable) wave of subprime lawsuits ' those related to insurance coverage ' builds momentum.

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 this article addressed the roots of the subprime crisis and resulting litigation, and provided an overview of D&O coverage. This month's installment focuses on specific D&O coverage issues.

Specific D&O Coverage Issues

The Insurers' Late Notice Defense

A defendant facing a subprime action and/or an insured that is the actual or potential target of a government investigation arising out of the subprime crisis should immediately notify its insurers under the notice provisions contained in their policies. Although not unique to D&O insurance, the issue of whether an insured gives timely notice will likely be one of the first, if not the first, issue analyzed from the insurers' perspective in any subprime claim.

The issue of notice is particularly important in D&O policies because such policies are almost always written on a 'claims-made' basis, as opposed to an 'occurrence' basis. Specifically, most D&O polices require that notice of claims be given 'as soon as practicable' and usually during the policy period, or alternatively within some short time period after the policy expires ' often referred to as the 'Discovery Period.' See 2 Knepper & Bailey, supra, '24.09. This 'extended reporting period' is usually 30 to 90 days. Id. Most courts have interpreted the phrase 'as soon as practicable' to mean 'within a reasonable time' under the facts and circumstances particular to the inquiry. See e.g., Argent Fin. Group Inc. v. Fid. & Deposit Co. of Md., No. 3:04CV02323, 2006 WL 1793609, *3 (W.D. La. June 28, 2006). Some D&O insurance is written on a 'claims-made-and-reported' basis. This arrangement is even more restrictive, requiring that both the claim against the insured and the notice of that claim to the insurer be provided during the policy period. Such policies, however, often give the insured the option of purchasing a 'Discovery Period' ' sometimes referred to as a 'tail' ' for the reporting of claims.

To ameliorate the harshness of strict notice requirements, many D&O policies allow insureds to provide early notice of circumstances that may, in the future, result in a potential claim. Such provisions in effect provide extended coverage past the policy period 'where 'facts and circumstances' that might give rise to a claim are known, but no 'claim' has been asserted against the insured.' In re Ambassador Group, Inc. Litig., 830 F. Supp. 147, 157 (E.D.N.Y. 1993).

In most jurisdictions (New York being the most notable exception), insurers may not base a refusal of 'occurrence based' insurance coverage on grounds of late notice unless they can show prejudice resulting from the timing of the notice. See The Argo Corp. v. Greater New York Mutual Ins. Co. , 827 N.E.2d 762, 765 (N.Y. 2005); see, also , Salt Lake Toyota Dealers Assoc. v. St. Paul Mercury Ins. Co., No. 2:05-CV-497 TS, 2006 WL 1547996, *4, (D. Utah June 6, 2006). The majority of jurisdictions, however, have refused to apply this notice-prejudice rule to claims-made policies, reasoning that allowing notice beyond the time defined in the policy provides the insured with an 'unbargained-for extension of the policy period.' See Id. n.39 (collecting cases from various jurisdictions). D&O insurers, therefore, in most instances need not show prejudice to sustain a disclaimer of coverage based on late notice.

Activities That Are Potentially Ultra Vires

As noted previously, under Side A coverage, a typical D&O policy provides for payment of a 'Loss … arising from' a claim made against the director or officer for an alleged 'Wrongful Act.' See Olson & Hatch, supra, at App. 12-1-2. Limitations in the definition of 'wrongful act,' however, may be key considerations with respect to D&O subprime claims. Specifically, a typical definition of 'Wrongful Act' may provide:

'Wrongful Act' means any breach of duty, neglect, error, misstatement, misleading statement, omission or act by the Directors or Officers of the Company in their respective capacities as such, or any matter claimed against them solely by reason of their status as Directors or Officers of the Company.

Id. at App. 12-1-3 (quoting AIG/ National Union policy); see also Id. at App. 12-2-14 (defining 'Wrongful Act' as 'any error, misstatement, misleading statement, act, omission, neglect, or breach of duty committed, attempted, or allegedly committed or attempted, by an Insured Person, individually or otherwise, in his Insured Capacity, or any matter claimed against him solely by reason of his serving in such Insured Capacity' (quoting Chubb policy form)).

By its terms, this is a broad coverage provision, applying to the enumerated wrongful acts or to any other claim against a director or officer 'solely by reason of' his or her status as an officer or director. See McAninch v. Wintermute , 491 F.3d 759, 769 (8th Cir. 2007). Although no longer typical, policyholders should be aware that some older policies restricted the definition of wrongful acts to acts of negligence. See Olson & Hatch, supra, '12:9; 2 Knepper & Bailey, supra, '24.07.

On the other hand, a potentially coverage-narrowing aspect of this definition is the requirement that the wrongful act be committed by a director or officer in his capacity as a director or officer. Thus, there will likely not be coverage for a director or officer for actions that are either ultra vires and/or in some other capacity (for example, that of an owner, a lawyer, trustee, partner, employee, or shareholder). See Olson & Hatch, supra , '12:9; 2 Knepper & Bailey, supra , '24.07; see also Olson v. Fed. Ins. Co. , 219 Cal. App. 3d 252, 263-64 (1990) (holding that acts of director were committed in capacity of shareholder, not director, and thus not covered as 'wrongful acts' under D&O policy). Courts, however, have not generally restricted coverage when a director or officer merely functions in more than one capacity within a corporation (for example director and owner, or director and shareholder), unless the insurer wishing to disclaim coverage can show that the person's dual capacity somehow relates to the alleged wrongful conduct for which coverage is sought. See McAninch, 491 F.3d at 772.

Therefore, when an individual assumes multiple roles within a corporation, including that of an officer or director, it may be important for policyholders to consider those roles separately when considering what types of insurance coverage to procure. Since a D&O policy may not cover liabilities associated with acts committed in some other capacity, other types of coverage (for example, professional liability coverage), if available, should be considered to provide seamless, or at least fuller coverage for corporate executives who wear more than one hat.

Similarly, there will generally not be coverage for the actions of a director of the insured entity when those actions are performed as a member of the board of another (non-subsidiary) entity, s ee Bowie v. Home Ins. Co. , 923 F.2d 705, 709 & n.4 (9th Cir. 1991); see also Olson , 219 Cal. App. at 260-61 (holding that acts committed by individual as owner of related company were not 'wrongful' acts of director of company named in D&O policy), although 'outside directorship' coverage can be purchased by separate endorsement. Olson & Hatch, supra, '12:9. Also, it may be important to review the company's bylaws to ascertain which executives and managers are considered 'officers' of the company, and thus whose wrongful acts are covered under the policy (or any policy endorsements).

Exclusions for Dishonest, Criminal, or Fraudulent Acts

D&O policies typically contain exclusions for dishonest, criminal, and/or fraudulent acts ('dishonesty exclusions'), which have been widely invoked in the past by insurers wishing to disclaim coverage. In particular, these exclusions factored prominently into D&O claims arising out of the S&L Scandal, and there is little reason to suspect that the exclusion will not be in the forefront of coverage disputes over subprime-related claims. The dishonesty exclusions take on various forms, some broadly excluding 'dishonest' acts, others also encompassing 'fraudulent,' and/or 'criminal' acts, and often also requiring that the excluded conduct be 'deliberate' or even 'deliberate and active.' See 2 Knepper & Bailey, supra, '25:03. The essence of all of these variations is the exclusion of coverage for certain conduct ' lacking probity ' for which insurance coverage would be inappropriate as a matter of public policy. See Olson & Hatch, supra, '12:13. One court chastised an insurer that attempted to apply the fraud exclusion to bar coverage for securities fraud, even though the policy's entity-side coverage expressly covered 'Securities Claims.' See Alstrin, 179 F. Supp. at 395-98. The court rejected the attempt to construe the entity coverage as applying only to unintentional conduct, '[p]articularly[ ] in a D&O insurance policy, where securities fraud claims are among the most common claims.' Id. at 398. The court held that the insured's reasonable expectations of coverage for 'Securities Claims' could not be eviscerated by the exclusion. Id. at 397-98. The scienter requirement to the dishonesty exclusions will generally except strictly negligent misrepresentations from the reach of the exclusion. See Int'l Surplus Lines Ins. Co. v. Univ. of Wyo. Research Corp. , 850 F. Supp. 1509, 1525 (D. Wyo. 1994); see also Continental Cas. Co. v. Tierney, No. 89-0679-CV-W-6, 1991 WL 207398 (W.D. Mo. July 2, 1991).

In general, a crucial aspect of the dishonesty exclusions is that they do not take effect upon mere allegations of dishonesty or fraud ' which would, in many cases, eviscerate the D&O coverage. Rather, the exclusions typically require either dishonesty 'in fact' or an actual adjudication of dishonesty, although some policy forms do not contain such an express qualification. Compare Alstrin, 179 F. Supp. 2d at 395 (excluding 'claims 'arising out of, based upon or attributable to the committing in fact of any criminal or deliberate fraud”), with In re Enron Corp. Secs. Derivative & 'ERISA' Litig. (Newby v. Enron Corp.), 391 F. Supp. 2d 541, 570 (S.D. Tex. 2005), and Int'l Surplus Lines v. Univ. of Wyo. Research Corp ., 850 F. Supp. at 1524 (requiring a judgment or 'final adjudication' of fraud).

In International Surplus Lines, the court concluded that a default judgment satisfied the exclusion's requirement of a 'final adjudication.' 850 F. Supp. at 1524. Cf. First Nat'l Bank Holding Co. v. Fid. & Deposit Co. of Md. , 885 F. Supp. 1533, 1537 (N.D. Fla. 1995) (holding that guilty plea resulting in a criminal conviction constitutes a 'final adjudication' for purposes of exclusion). As noted, some D&O policies do not contain this requirement, see Olson & Hatch, supra, '12:13, so it is important that a prospective D&O policyholder be sure that its policy does not exclude coverage on mere allegations of dishonesty. Thus, for example, when the directors or officers of an investment bank are sued under federal securities laws for their participation, or acquiescence, in the creation, marketing, or securitization of subprime debt (as for example, in the Plumbers' Union Complaint, supra, in which plaintiffs allege that Swiss Reinsurance Company violated the 1934 Securities and Exchange Act by failing to disclose that it had written certain subprime-based derivatives (default swaps) that allegedly 'exposed the Company to great financial risk') the mere allegation of fraud inherent in the claim or charge probably will not in most cases act as a bar to coverage until such fraud has been adjudicated or otherwise rendered a fait accompli.

Another important aspect of the dishonesty exclusion of which a prospective policyholder should be cognizant is whether the dishonest acts of individuals are severable vis-'-vis other directors and officers; in other words, whether dishonest acts of one insured are necessarily imputed to all insureds. Obviously, the D&O shopper should seek coverage for which the dishonesty exclusion is severable as among insureds. Outcomes and arguments, however, may vary depending inter alia on specific policy language and the factual circumstances surrounding a particular claim.

An important issue for a D&O policyholder facing a subprime lawsuit raising claims of fraud or dishonesty (for example, securities fraud) will be whether the insured's defense expenses are reimbursable under the policy. In the high-profile litigation involving the directors and officers of Enron Corporation, a federal district court had an opportunity to address this issue. The issue in Newby v. Enron Corp. was whether the insureds, directors, and officers of Enron were entitled to ongoing payment of defense costs in criminal proceedings against them. 391 F. Supp. 2d at 557-58. The policy at issue excluded coverage:

for specific claims brought about or contributed to by the dishonest, fraudulent, criminal or malicious act or omission of [a] DIRECTOR or OFFICER if a final adjudication establishes that acts of active and deliberate dishonesty were committed or attempted with actual dishonest purpose and intent and were material to the cause of action so adjudicated. Id. at 570.

A dishonest or fraudulent act need not be criminal to fall within the exclusion. See Int'l Surplus Lines v. Univ. of Wyo. Research Corp ., 850 F. Supp. at 1523. The court found the policy as a whole to be ambiguous and interpreted the exclusion in favor of the insureds, holding that their criminal defense costs were covered, 'but only where the insured is ultimately found not guilty of having committed or attempted to commit acts of dishonesty, fraud, or criminality.' 391 F. Supp. 2d at 573. If the insureds were ultimately convicted of an act of fraud or dishonesty, they would be required to pay back the fronted defense costs to the insurer. Id. at 575.

Perhaps even more significantly, the Newby court followed the majority of courts in also holding that where there is a potentially applicable dishonesty exclusion, an insurer must pay its insured's defense costs as they are incurred. Id. at 573. Considering the ubiquity of fraud and dishonesty allegations in the types of claims to which corporate officers and directors are subject, the court held that requiring an insured to advance his own defense costs until there had been a favorable disposition regarding fraud or dishonesty 'could bring financial ruin upon a director or officer.' Id. at 574. The Newby court, however, also noted that some courts had rejected imposing a duty of ongoing reimbursement of defense costs on insurers. Id. n.40. Some of those cases involved an 'option clause' that explicitly gave the insurer the option (not a duty) to pay defense costs on an advance basis. Id . (citing Zaborac v. Am. Cas. Co. of Reading, Pa. , 663 F. Supp. 330 (C.D. Ill. 1987); Luther v. Fid. & Deposit Co. , 679 F. Supp. 1092 (S.D. Fla. 1986)).

But at least one court holding that a D&O insurer has no duty to advance defense costs as incurred acknowledged that the policy under consideration did not contain an option clause. Kenai Corp. v. Nat'l Union Fire Ins. Co ., 136 B.R. 59, 63-64 (S.D.N.Y. 1992) (citing cases holding that insurer has no duty to advance defense costs, acknowledging that policy before it did not contain 'option clause,' and holding that 'the plain meaning of the terms of the D&O policy at issue here' does not require the insurer to advance defense costs), cited in Newby , 391 F. Supp. at 574 n.40. That court reasoned that requiring an insurer to advance defense costs even for claims that would turn out not to be covered under the policy would prejudice insurers, even if the insured was required to reimburse the insurer for those uncovered defense costs. Kenai Corp., 136 B.R. at 64.

The Insured vs. Insured Exclusion

The insured versus insured exclusion seeks to bar coverage for suits between the corporate policyholder and its directors and officers. Fid. & Deposit Co. of Md. v. Zandstra , 756 F. Supp. 429, 432 (N.D. Cal. 1990). The exclusion first arose in the early 1980s when financial institutions, in an attempt to access their D&O insurance coverage, sued their own directors and officers for loss resulting from underperforming loans. Thus, the fundamental purpose of the exclusion was to prevent collusive lawsuits. See Olson & Hatch, supra, '12:14. Additionally, a host of new issues may arise out of the exclusion based upon the expanded definition of 'Insured' under many current D&O policy forms, which, in addition to officers and directors, may include employees or trustees of the corporation, among other individuals. It is also important to note that the corporation itself may also be included as an 'Insured' under the D&O policy, particularly if Side C 'entity' coverage is purchased.

Some courts have upheld the insured versus insured exclusions as clear and unambiguous, even while recognizing that the underlying purpose of the exclusion, i.e., to avoid collusive suits, is not necessarily furthered by its application. See , e.g. , Sphinx Int'l, Inc. v. Nat'l Union Fire Ins. Co. of Pittsburgh, Pa ., 226 F. Supp. 2d 1326, 1337 (M.D. Fla. 2002) (holding that when former officer and director was involved in underlying securities class action, 'the lack of collusion in the underlying suit does not bar the application of the insured v. insured exclusion … and the exclusion covers the claims of all the plaintiffs in the instant securities suit.'); see also Level 3 Communication, Inc. v. Fed. Ins. Co. , 168 F.2d 956 (7th Cir. 1999). Accordingly, some D&O policies now carve out shareholders' derivative suits from the insured versus insured exclusion, expressly preserving coverage for such suits. See Olson & Hatch, supra, '12:14; see also, Zandstra, 756 F. Supp. 429. The policy in Zandstra was typical in that it contained an exception to the insured versus insured exclusion for a 'shareholders' derivative action by a shareholder of the [insured], when such shareholder is not a Director or Officer of the [insured].' Id. at 430. Furthermore, the court noted that this exception to the exclusion 'demonstrates [the insurer] intended to place itself on the risk for actions against the directors and officers based upon allegations of mismanagement, waste, fraud, or abuse of [the insured corporation].' Id. at 431. Other policy forms, however, do not provide for any such carve outs.

In addition to shareholder derivative actions, other types of subprime lawsuits may implicate the insured versus insured exclusion, including, for example, ERISA suits by employees and/or pensioners or bankruptcy trustee suits against former directors and officers ' particularly where the definition of 'Insured' includes employees and trustees as noted above. See Frederic Giordano and Sherilyn Pastor, What Bank Directors and Officers Should Know About D&O Insurance, Community Banker (Nov. 2007) ('Some courts have found that the bankruptcy trustee steps into the company's shoes such that the exclusion applies. Other courts have declined to apply the exclusion in those circumstances because such suits are not collusive. Many insurers have narrowed the exclusionary language so that it does not apply to directors and officers who have not held their position for a set number of years or to claims brought by a bankruptcy trustee.').

Rescission

It is estimated that 130 companies have taken a total $257 billion in write-downs related to the subprime crisis. Thomson, supra. These accounting revisions portend a potential ground on which an insurer might seek to deny coverage ' insurers may argue for rescission of the policy based on alleged misrepresentations in the insurance application. Specifically, an insurer might argue that it would not have written the policy as it did, or would have charged a higher premium, or would not have issued the policy at all, had the 'true' financial condition of the insured been known from the outset.

Restatements of a company's financial condition, however, are not uncommon and not always indicative of prior misstatements or omissions. Rather, the restatements are far more likely to indicate a legitimate change in accounting practices or a revision based on unforeseen circumstances and events. See Josephine H. Hicks, D&O Coverage in the Post-Enron World, Coverage (Dec. 2002). Thus, depending on the jurisdiction, in order to prevail on a rescission claim, an insurer most likely must demonstrate that the representation was not only false, but also that it was material and relied on by the insurer, or that it was intentional, or that it was either material or fraudulent. See Id. The materiality requirement is often central to the issue. If an insurer can show that prior misstatements significantly influenced its underwriting decisions, it may have a stronger rescission claim. See Id.

Policy language is often the key in determining the scope of an insurer's rescission rights. In Federal Insurance Co. v. Homestore, Inc. , 144 Fed. Appx. 641 (9th Cir. 2005), for example, the court held that California public policy did not bar insurers from rescinding a D&O policy when the company's chief financial officer, and signer of the insurance applications, made material misrepresentations in the company's financial statement. After reviewing that statement, Homestore's board of directors issued a 'restatement' of the company's financial condition, revealing a prior significant overstatement of advertising revenues. Securities claims and shareholders derivative suits followed. Id. at 645.

The primary D&O policy provided that statements contained in the application, as well as any materials submitted with it, were deemed part of the policy. Id. The policy also provided that if the information in the application or materials submitted contained material misrepresentations, then:

no coverage shall be afforded … for any Director or Officer who did not sign the Application but who knew on the inception date of this Policy the facts that were so misrepresented, and this Policy in its entirety shall be void and of no effect whatsoever if such misrepresentation were known to be untrue on the inception date of the Policy by one or more of the individuals who signed the Application. Id.

The Ninth Circuit, affirming the District Court, held that the policy 'anticipates rescinding coverage to all Insureds without knowledge of misrepresentations, based upon material misrepresentations known to a signer.' Id . at 647; see also Shapiro v. Am. Home Assurance Co. , 584 F. Supp. 1245, 1252 (D. Mass. 1984) (imputing misrepresentation to 'innocent' insureds because statements in application 'misrepresented the risk incurred in insuring all those covered by the policy'); Bird v. Penn Central Co. , 334 F. Supp. 255 (E.D. Pa. 1971) (imputing misrepresentation to all insureds based on theories of agency and ratification).

Similarly, a restatement of earnings was the basis for an insurer's attempt to rescind a D&O policy, based on alleged misstatements and omissions in the renewal application, in Executive Risk Indemnity, Inc. v. AFC Enterprises, Inc . 510 F. Supp. 2d 1308 (N.D. Ga. 2007). The restatement spawned a flurry of securities class actions and shareholder derivative suits against the company. Id. at 1317-18. The policy at issue limited the insurer's ability to rescind based on a misrepresentation in the application only as to those persons who knowingly made material misrepresentations and who signed the application. Id. at 1324-25. Because the individuals who signed the application provided information only 'to the best of [their] knowledge and belief,' and because they also credibly testified that they believed the pre-restatement disclosures were accurate, the court rejected the insurer's rescission claim. Id. at 1325-28.

In any event, applications for D&O insurance include questions about whether the insured has any knowledge of actions or omissions that might give rise to a claim under the policy. In the midst of the subprime crisis, it is vitally important that prospective D&O policyholders, and those renewing existing D&O coverage, answer these questions in a forthright manner at risk of losing the D&O coverage entirely. Indeed, the D&O application should be prepared with extreme care and precision.

Conclusion

The crisis affecting the subprime mortgage market has already implicated D&O insurance providers to an unprecedented degree, and it will undoubtedly continue to do so. And while the present subprime turmoil is of recent vintage, many of the coverage issues that are likely to arise in the wake of the crisis are not new. As potential liabilities related to corporations' involvement in the sale, underwriting, marketing, and/or securitization of subprime mortgages continue to be hashed out in the courts, policyholders and their insurers will not lose sight of where the money to fund the defense and indemnity of these suits will come from. If past financial disasters are any indication, policyholders and insurers will fight vigorously to protect their interests. This article has addressed some of the more prominent coverage issues likely to arise in the subprime context, and has provided some guidance as to how those issues might play out when the second (and perhaps inevitable) wave of subprime lawsuits ' those related to insurance coverage ' builds momentum.

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.