Paying D&O Insurance Claims is Not Morally Wrong

Judicial Fabrication of Public Policy Exclusions is Not Permitted
The Judicial Fabrication of “Public Policy” Exclusions Should Not Be Permitted

Insurance carriers have seldom been considered protectors of public morality.  When insurers make the argument that they are denying claims for the benefit of the public, more often than not, judges and juries see through the nonsense and hit them with bad faith and punitive damages awards for putting their financial interests above the interests of the policyholder they agreed to protect.  Nonetheless, insurers keep trying.  Their newest twist is arguing that it is immoral for them to pay certain kinds of Directors & Officers (“D&O”) insurance securities claims.  Their argument is that covering breach of contract claims arising out of the sale and purchase of securities creates a “moral hazard.”  If they pay these claims, the insurers’ reason, corporations will be incentivized to breach securities-related contracts because insurance would protect them on the back-end of a deal gone bad.  Although this argument has no support in policy language, insurers continue to raise the argument, and this will likely do so until courts see the argument for what it is, a bad faith attempt to avoid paying legitimate D&O securities claims.

Typical Stock Purchase Agreement Scenario

A public company in its early stages of development, secures additional funding from an investment firm, but the company gets sued by that outside investor claiming that the company failed to honor an agreement giving the outside investor the right to purchase securities, in exchange for that investor’s promise to provide the company with much needed funding.  At the time of the alleged breach, the investor had not paid any money for company shares, which at the time were trading at $2.50 a share. Ten months later, it is trading at $14.75 a share, and magically the investor contends that it was ready, willing and able to purchase those lower price shares ten months earlier, and has since lost out on the share price increase.   The good news is that the company’s D&O insurance policy covers claims alleging wrongful acts or omissions in the sale or purchase of company securities, and, as with many D&O insurance policies, the company’s policy does not contain an exclusion for breach of contract claims.

The Insurers’ Response

The company in the above scenario rightly expects its insurer to accept coverage and pay for, at a minimum, its attorneys’ fees incurred in defending the action. After all, the investor’s lawsuit is a classic securities claim.  Unfortunately, that is not how insurers are handling these types of claims.  Rather than honoring the express terms of their policies, D&O insurers have cloaked themselves in the veil of morality by arguing that their policies do not, should not, and cannot cover such claims because of an inherent “moral hazard.”  To the dismay of policyholder corporations, insurers are actually arguing that it is against public policy to cover breach of contract claims involving the sale or purchase of company securities because somehow, if such claims were paid, that would have the perverse effect of encouraging their insureds to intentionally breach contracts with business partners.

Outlier Case Law Distractions

Insurers point to a handful of cases around the country which they contend support this moral hazard theory, including the decision by a federal appellate court in The May Department Stores Company v. Federal Insurance Company, 305 F.3d 597 (7th Cir. 2002).  In May, a number of class actions were filed against the policyholder by benefit plan participants alleging breach of contract claims for the insured company’s failure to properly fund and pay certain benefits.   Ultimately, the insured company settled with the plan participants by paying a substantial amount of money to reimburse the plan participants for the alleged underpayments within the plan.  The insured’s fiduciary insurer denied coverage for these class actions.  The court agreed with the insurer, stating that:

[I]t would be passing strange for an insurance company to insure a pension plan (and its sponsor) against an underpayment of benefits, not only because of the enormous and unpredictable liability to which a claim for benefits . . . could give rise, but also because of the acute moral hazard problem that such coverage would create. . . . Such insurance would give the plan and its sponsor an incentive to adopt aggressive (just short of willful) interpretations of ERISA designed to minimize the benefits due, safe in the belief that if, as would be likely, the interpretation were rejected by the courts, the insurance company would pick up the tab.

Id. at 601.

The court in May, rather than applying the clear and unambiguous terms in the policy, opted instead to deny the claim on its belief, without any supporting data or case studies, that a finding in favor of coverage would invariably lead the insured (and other insureds) to purposefully breach employee benefits contracts, and other business contracts, on the expectation that insurance would cover it in the event its counter-party filed suit.

Policyholder Considerations

The Seventh Circuit in May, and a handful of other courts, have strayed from express policy language.  Believing that courts should proactively determine what companies might or might not do if insurance is ultimately available to pay a claim, they have created this moral hazards theory out of rank speculation.  What is “passing strange” is not for an insurer to cover a breach of contract claim, but for a court to refuse to apply the express terms in an insurance policy in favor of some esoteric sociological theory of human behavior.

Of course, these courts also completely ignore the fact that it is against a corporation’s best interest to engage in willful or intentional misconduct which will likely result in a lawsuit, on the hope that insurance may be available.  For starters, no company purposefully tries to get itself sued, no matter what type of hypothetical future financial support it might have.  Litigation is time-consuming, distracting, unpredictable, and incredibly expensive.  May and its progeny also ignore the importance of self-insured retentions (SIRs), which can be quite high for fiduciary and D&O insurance programs.  Again, a company would not feel protected by insurance if it knew that it would be responsible for a multi-million dollar SIR, all on the mere possibility its insurer may agree to cover over that limit.

The May line of cases also ignores, or simply disregards as not particularly relevant, that certain D&O policies do not contain contractual liability exclusions.  Although private company D&O policies may contain contractual liability exclusions, public company D&O insurance policies providing coverage to the insured entity for “securities claims” under Side C coverage typically do not contain contractual liability exclusions.  This distinction between private and public company D&O policies is important because it demonstrates that the insurance underwriting community intends to cover contractual liability claims involving securities claims, such as claims involving stock purchase agreements.  In other words, insurers may not have intended to cover any and all breach of contract claims, but they certainly agreed to insure breach of contract claims involving the purchase or sale of the insured’s securities.  For this fairly narrow but very important band of contract claims, D&O insurers have contractually committed themselves to cover their public company insureds.

The other issue with these outlier court decisions is that they all involve situations where the insured company received some sort of direct benefit from its alleged breaches of contract, either by way of retaining money that was otherwise owed to others (in May, the plan participants) or by receiving money from a counter-party to a contract but not fulfilling its contractual obligations.  In those situations, the no-coverage determination by those courts may have some appeal, not based on moral hazard, but because the insured did not lose any money, but simply returned something it did not otherwise deserve.  Policies address this issue through use of an exclusion for ill-gotten gains – “remuneration, profit or other advantage to which the insured was not legally entitled to.”  In contrast, in the stock purchase scenario described above, the risk to the insured company is paying money to the investor for its alleged loss of opportunity, not for money that investor has paid the insured.  As such, the ill-gotten gain exclusion has no application here, but it does illustrate the point that courts should not fabricate exclusions based on public policy concerns.

Conclusion

If a policyholder is sued for breach of contract in a claim involving the sale or purchase of securities, public company D&O insurance should provide cover. This is just one example of how insurers have gone on the offensive to deny claims based on nonexistent public policy concerns.  When an insurer argues that there is a public policy against insuring intentional acts because doing so creates a moral hazard, they are not doing so to protect the public good.  They are making the argument to support a claim denial.  Policyholders dealing with this issue should retain coverage counsel to let the insurers know that their public policy argument is improper and should be abandoned.  This is one area where clear policy language does not support denial of a claim.  That should be all that a court needs to uphold coverage.

For additional information about this post, please email or call Brian Friel (FrielB@millerfriel.com or 202-760-3162).

Leave a Reply

Your email address will not be published.

Please prove that you are not a machine. *

This site uses Akismet to reduce spam. Learn how your comment data is processed.