D&O Insurance: Defense Costs Incurred in Informal SEC and Internal Investigations

D&O Insurance: Defense Costs Incurred in Informal SEC and Internal Investigations

Among the most frequently recurring and arguably most vexatious D&O insurance coverage issues are the questions of the carrier's obligation under the policy for defense expenses incurred either in connection with an informal SEC investigations or an internal investigation.

In an October 15, 2010 summary judgment ruling in insurance coverage litigation involving Office Depot, Southern District of Florida Judge Kenneth Marra, applying Florida law, denied coverage for both of these categories of defense expense. Though the decision is a direct reflection of the specific facts involved and the particular policy language at issue, the ruling provides an interesting insight into these recurring issues.

Background

In June 2007, Office Depot was the subject of news report suggesting the company had improperly disclosed material information to securities analysts in violation of Sec. Regulation FD. In a July 17, 2007 letter, the SEC advised Office Depot it was "conducting an inquiry" to determine whether the securities laws had been violated, and requested certain information from Office Depot "on a voluntary basis." Office Depot opted to voluntarily cooperate by providing documents and making its employees and officers available for sworn testimony. On July 31, 2007, the SEC requested that Office Depot preserve the records of numerous employees and offices, which it identified by job title.

Office Depot forwarded the letter to its insurers. Office Depot's primary insurer accepted the letter as a "Notice of Circumstances" that may give rise to a claim.

In addition, in July 2007, before it received the SEC's informal inquiry, Office Depot received an internal whistleblower letter raising concerns relating to the timing of Office Depot's vendor rebate funds. Office Depot self-reported the whistleblower allegations to the SEC, which expanded its inquiry to include the whistleblower allegations. The company's audit committee conducted its own investigation of the allegations, retaining lawyers, accountants and consultants for those purposes. The internal investigation resulted in Office Depot's restatement of its 2006 financial statements.

In November 2007, two shareholder derivative lawsuits and two securities class action lawsuits were filed against the company. The shareholder suits alleged misrepresentations in connection with the company's financial reporting of vendor rebates. In January 2010, the defendants' motions to dismiss the securities class action lawsuit were granted. The dismissal is now on appeal. The plaintiffs in the derivative lawsuits voluntarily dismissed those cases.

In January 2008, the SEC issued a formal "order directing private investigation" and during the course of 2008 subpoened the company and at least eight current and former Office Depot officers and directors, including several who previously voluntarily testified. The notice did not name any individuals as wrongdoers. In November and December 2009, the SEC issued Wells notices to three Office Depot officers. In December 2009, the company reached an undisclosed settlement with the SEC staff.

Office Depot requested reimbursement from its D&O insurers of the over $23 million the company had incurred in responding to the SEC, indemnifying individuals against defense expenses, and conducting an internal investigation of the whistleblower allegations.

The primary carrier acknowledged its obligation to reimburse Office Depot for defense costs incurred by officer and directors after having been served with SEC subpoenas and Wells notices, and for the costs incurred in the four securities lawsuits. However, the approximately $1.1 million of acknowledge expenses did not exceed the policy's $2.5 million retention. The primary insurer denied coverage for the other expenses, and Office Depot filed an action alleging breach of contract and seeking a judicial declaration of coverage. Office Depot's excess D&O insurer intervened the action.

The parties filed cross motions for summary judgment.

The October 15 Ruling

The insurers argued that there is no coverage for Office Depot's costs incurred in voluntarily responding to the SEC's investigation and for the costs of Office Depot's internal investigation of the whistleblower allegations because the costs did not arise either because of a "Securities Claim" against Office Depot or a "Claim" against an insured director or officer. All policy references below refer to the language of the primary policy.

The policy's definition of Securities Claim contains threshold language that excludes from the term "an administrative or regulatory proceeding against, or investigation of, an Organization." However, the definition contains a "carve back" which specifies that the term Securities Claim "shall include an administrative or regulatory proceeding against an Organization, but only if and only during the time that such proceeding is also commenced and continuously maintained against an Insured Person."

Judge Marra found it significant that the threshold language excluded coverage for "an administrative or regulatory proceeding against, or investigation of" an Organization, but the carve back preserving coverage refers only to "an administrative or regulatory proceeding" - and thus the carve back does not refer to "an investigation" as does the threshold language. Judge Marra concluded that "the carve-back clause does not restore coverage for 'an investigation of' the Organization"

Judge Marra also found the policy's definition of "Claim" distinguishes between "a proceeding for relief" and an "investigation of an insured person," specifying that an investigation constitutes a "Claim" only once the insured person has been notified in writing that he or she may be a target or after service of a subpoena.

In addition, Judge Marra rejected Office Depot's argument that the term "proceeding" was broad enough to encompass the SEC's informal and formal investigation of Office Depot. In reaching this conclusion, Judge Marra referenced the policy's distinction between "proceedings against" and "investigations of" insured persons and organizations. Judge Marra said this distinction can only be given "any meaning" by giving the term "proceeding" its "plan meaning," which he defined as "a formal legal action or hearing conducted in a court of law or some official tribunal."

Judge Marra concluded therefore that the company's costs of voluntarily responding to the SEC do not represent "loss of the Organization arising from a Securities Claim."

Judge Marra also concluded that the voluntary, pre-subpoena costs incurred on behalf of the individual directors and officers were not incurred in connection with a "Claim." In reaching this conclusion he specifically referenced the trigger required to bring an "investigation" within the definition of "Claim."

Office Depot had argued further that the policy's "relation back" language brought all of the pre-claim costs within coverage when the claims finally did emerge. Office Depot made this argument in reference to the language in the policy's notice provisions which provide that when a policyholder provides a notice of circumstances that could give rise to a claim, and a claim subsequently arises, the claim relates back to the time of the original notice.

Judge Marra ruled that the "relation back" language pertained solely to the question of when a "Claim" is first made for purposes of determining the appropriate claims made policy period. The relation back language, Judge Marra said, "simply serves to identify the policy period in which the 'subsequent Claim' was made; it does not operate to expand the Policy definition of 'Claim' to absorb any allegations of wrongdoing which happen to be related or similar to the wrongdoing described in the insured's original Notice of Circumstances."

Judge Marra also rejected Office Depot's related argument that the November 2007 securities lawsuit "relate back" to provide coverage for the company's internal investigation. The company had argued that because the subsequent lawsuits were "subsequent claim," the Policy's "relation back" language brought under the Policy's coverage all defenses expenses incurred from the date of the Notice of Circumstances.

Judge Marra said that even if the securities suits were "subsequent claims" that relate back for notice purposes to the date of the original notice of circumstances, "it does not follow that any pre-suit investigation costs which may have related to and benefitted the defense of those suits...are transformed into a covered 'loss' which 'arises from' that securities litigation."

Finally, Judge Marra held that the Policy's definition of covered Loss does not include the costs of investigating potential or anticipated claims, rejecting Office Depot's argument that those costs are "arising from" the defense of a claim. He found that the "arising from" phrase "connotes a sequential relationship" between the Claim and the Loss that "arises from it" - that is, Loss that "follow sequentially in time." He said that covered loss "does not include related pre-suit or pre-claim investigation costs, regardless of how 'related' or 'beneficial' those costs may have ultimately proved to be in defending against the claim which ultimately materialized." He added that "while these costs may well have reasonably been incurred in contemplation of anticipated or potential litigation, that is not enough to meet the Policy's requirement that the 'resulted solely from' the investigation or defense of a Claim."

Discussion

Judge Marra's analysis and conclusions are a direct reflection of the specific language at issue in the Office Depot case, and his analysis might or might not produce the same or similar outcome under different policy language. He seemed particularly persuaded that Office Depot's primary D&O policy draws a clear distinction in how the policy responds to "investigations" on the one hand and "proceedings" in the other.

That said, Judge Marra's analysis is quite detailed and represents a very thorough examination of what policyholders are entitled to under the policy before an investigation ripens into a formal administrative or regulatory proceeding. The opinion also represents a detailed examination of what insurers are responsible for before a claim has been made under the Policy.

Insurers will undoubtedly welcome this decision and will attempt to rely on it in other cases. As a district court opinion, the decision has limited precedential value, but the insurers will seek to rely on the decision for its persuasive value. The extent to which other courts will follow Judge Marra necessarily will depend on the policy language at issue in the other cases. Indeed, Judge Marra himself rejected Office Depot's attempt to rely on prior decisions in which courts had held that an "investigation" is a "proceeding," stating that the policies involved in those other cases involve different language.

Notwithstanding Judge Marra's decision, policyholders will continue seek coverage for defense costs incurred in informal investigations and for internal investigation, particularly where distinction in policy language would seem to justify a different outcome. The sheer dollar costs involved alone (see, e.g., Office Depot's $23 million in expenditures) ensure that policyholders will continue to agitate on these issues.

Given the perennial nature of these issues, the question arises of what are the practical lessons of Judge Marra's opinion. The most important lesson seems to be that the policy's wordings of "Securities Claim" and "Claim" are very important and the specific wording used with relation both to "investigations" and "proceedings" can be critically important. A critically important issue for insurance buyers and their advisors to keep in mind is that a court may differentiate "regulatory and administrative proceedings" on the one hand and "investigations" on the other hand, and it is critically important to analyze coverage with respect to these two sets of considerations separately.

One final note relates to Judge Marra's analysis of whether pre-claim defense expenses may be said to be "arising from" a subsequent claim. Judge Marra reduced this analysis to a question of temporal relation, in effect concluding that any particular item of defense expense can only "arise from" a claim if it comes later in time. I am not sure this analysis takes into account all of the possibilities, In particular, there are occasions when defense expenses are incurred earlier that would inevitably have been incurred later, the argument being the expenses "would have been incurred in any event" and the fact that they were incurred prior is an accident of timing. Arguably, Judge Marra's analysis is not (or perhaps fairly ought not to be) preclusive of this argument.

It is probably worth noting that there have been recent innovations introduced into the D&O insurance marketplace designed to try to provide coverage for certain preclaim expenses incurred by or on behalf of individual directors and officers. The most recent formulations would not address the pre-claim expenses or internal investigative expenses of the insured entity itself, but it would at least provide direct or reimbursement coverage for costs incurred by or on behalf of individuals before a "Claim" has emerged.

These issues surrounding informal inquiries and internal investigations raise many points of contention, and policyholders and their insurers will continue to struggle with these issues. It seems probable that insurers facing these disputes will attempt to rely on Judge Marra's opinion.

Special thanks to Steve Brodie of the Carlton Fields law firm for providing me with a copy of Judge Marr's opinion. The Carlton Fields firm represented the primary insurer in the coverage litigation.

For discussion of a recent decision in which a court held that there was coverage under a D&O insurance policy for investigative expenses of a special litigation committee, refer here.

Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.