Final Adjudication of Regulatory Enforcement Actions and Its Effect on D&O Insurance Coverage: Recent Developments

Final Adjudication of Regulatory Enforcement Actions and Its Effect on D&O Insurance Coverage: Recent Developments

By Gregory J. May, Partner, Nelson Mullins Riley & Scarborough LLP

In the wake of the 2008 crash, federal regulators, including the Securities and Exchange Commission ("SEC") and the Federal Deposit Insurance Corporation ("FDIC"), have markedly increased their investigation and prosecution of financial institutions and their executives. Directors, officers and entities facing civil and criminal investigations and proceedings brought by government agencies look to avoid or limit any liability on the best terms possible whether by taking the matter to trial or by reaching a settlement.1 Resolution of the proceedings short of trial obviously may result in incarceration or payment of penalties by the targeted directors or officers. The form and timing of the resolution may also affect whether there is coverage for the claims under the applicable directors and officers insurance ("D&O") policy.

D&O policies uniformly contain provisions that bar coverage where a "final adjudication or judgment" determines that the insured has engaged in certain conduct giving rise to the insurance claim.

For example, most if not all D&O policies contain an exclusion barring coverage where the insured is proven by a "final adjudication or judgment" to have engaged in fraudulent or dishonest conduct.

Many times, the targeted company, director or officer decides that the risk of taking the proceedings to trial is too great, and agrees to settle with the prosecuting or investigating agency. The settlement may result in an administrative order or consent order that contains a description of the wrongful conduct at issue.

For example, administrative settlements entered into by the SEC contain "findings" that lay out in detail the SEC's case against a targeted director and that are sometimes offered by future litigants in other litigation as proof of the director's guilt.2 Because the settlement agreement is reached at the same time that these "findings" are entered, coverage questions may arise as to whether these "findings" constitute a "final adjudication" of facts that arguably brings the claims within D&O policy exclusions.

Also, where entry of a "final judgment" triggers an exclusion rendering the claim uncovered under the policy, questions arise as to whether defense costs advanced by the D&O insurer prior to entry of the judgment can be recouped by the insurer from the insured.

Two recent decisions from courts in two jurisdictions busy with regulatory proceedings provide practitioners representing insurers and insureds with guidance as to the effect of settlements and guilty pleas on D&O coverage.

I. J.P. Morgan Securities, Inc. v. Vigilant Insurance Company: Do SEC "Findings" Mean "Final Adjudication"?

In J.P. Morgan Securities, Inc. v. Vigilant Insurance Company,3 the Supreme Court of New York County, New York, considered whether insurance coverage existed for Bear Stearns' alleged violations of federal securities laws. The primary issue was whether an administrative settlement in which the SEC made "detailed findings" about Bear Stearns' facilitation of late trading and market timing practices constituted a "final adjudication" of fraudulent conduct that barred coverage under a fraud exclusion.

The SEC began its investigation of Bear Stearns' alleged late trading and deceptive market timing (primarily conducted on behalf of its large hedge fund clients) in 2003, and later indicated its intent to file a civil proceeding seeking injunctive relief and sanctions in excess of $700 million.4 In its Wells submission, Bear Stearns disputed the SEC's proposed charges.5

However, Bear Stearns later made a formal offer of settlement of the charges, which was accepted by the SEC in 2005.6

The SEC subsequently issued an "Order Instituting Administrative and Cease-and-Desist Proceedings, Making Findings, and Imposing Remedial Sanctions" ("Order") in which Bear Stearns agreed to pay $160 million as disgorgement and $90 million as a civil penalty.7 The Order set forth 40 pages of "detailed findings," which stated that Bear Stearns "facilitated a substantial amount of late trading and deceptive market timing"; "knowingly or recklessly processed thousands of late trades"; "took no steps to alter [its] procedures or to implement effective measures to stop deceptive timing"; and "took affirmative steps to hide from mutual funds the identity of customers that were known market timers."8

However, Bear Stearns also stated that its agreement to the Order was "solely for the purpose of these proceedings" and was "without admitting or denying the [SEC's] findings."9

After paying the settlement with the SEC, Bear Stearns demanded indemnity from its primary and excess D&O insurers who disclaimed coverage on multiple grounds. In particular, the insurers asserted that the applicable "Dishonest Acts Exclusion" ("Exclusion") barred coverage because the Order constituted "final adjudication" of Bear Stearns' dishonest conduct. The Exclusion stated that the policies did not apply to:

[A]ny Claim(s) against the Insured(s) . . . based upon or arising out of any deliberate, dishonest, fraudulent or criminal act or omission by such Insured(s) provided, however, such Insured(s) shall be protected under the terms of this policy with respect to any Claim(s) made against them in which it is alleged that such Insured(s) committed any deliberate, dishonest, fraudulent or criminal act or omission, unless judgment or other final adjudication thereof adverse to such Insured(s) shall establish that such Insured(s) were guilty of any deliberate, dishonest, fraudulent or criminal act or omission "10

The D&O insurers asserted that the SEC's "detailed findings" of fraudulent and dishonest conduct were a "final adjudication" as described in the Exclusion and, therefore, the insurers had no duty to indemnify Bear Stearns.

The J.P. Morgan court disagreed. According to the court, the Order was "the product of a settlement" between Bear Stearns and the SEC, and Bear Stearns consented to entry of the orders "solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the [SEC]."11

The J.P. Morgan court further reasoned that Bear Stearns did not admit to the SEC's factual findings, detailed as they were. The court appeared especially troubled by the fact that the findings were not the "subject of hearings or rulings on the merits by a trier of fact," but rather were unilateral findings by the government agency that brought the administrative proceeding.

Also, the court described the Order as a mere "settlement" evidenced by Bear Stearns' express reservation of the right to take positions contrary to the SEC's detailed findings in other cases where the SEC is not party.12 In other words, because Bear Stearns specified that its agreement to the Order was "for the purposes of [the SEC's instant] proceedings only," the Order could not be final in that it could not have any collateral estoppel effect in other actions.13

The J.P. Morgan court concluded that the D&O policy language simply did not support the insurers' position that the term "final adjudication" encompasses settlements of an administrative order. The court relied on precedent holding that exclusionary language must be written in "clear and unmistakable language" to find that the Exclusion's use of "final adjudication" could not include the Order which was the product of a settlement.14

II. Protection Strategies, Inc. v. Starr Indemnity & Liability Company: Does "Final Adjudication" Mean Full Recoupment Or Only Prospective Recoupment Of Advanced Defense Costs?

In Protection Strategies, Inc. v. Starr Indemnity & Liability Company,15 the United States District Court for the Eastern District of Virginia decided that an insured's officers' guilty pleas constituted "final adjudication" of facts such that D&O policy exclusions applied to bar coverage and that the insurer was entitled to recoupment of the defense costs it had advanced to the insured corporation and its officers.

Protection Strategies, Inc. ("PSI"), was accused by the NASA Office of Inspector General and the Department of Justice ("DOJ") of false claims, conspiracy, mail fraud and wire fraud, and false statements to the Small Business Administration ("SBA").16 In essence, certain PSI officers engaged in a scheme to defraud the SBA, NASA, the Department of Defense and several other federal agencies by setting up a shell corporation and representing that it was eligible for SBA contracting preferences so as to obtain government contracts PSI would not have been able to obtain.17

After investigation by the DOJ throughout 2012 and 2013, the PSI officers agreed in March 2013 to enter into plea agreements stipulating that each officer knowingly and willfully took actions in furtherance of fraud from 2003 until 2012. Final judgment (which included prison sentences and fines) subsequently was entered against the officers by a federal court.18

PSI provided notice to its D&O insurer, Starr, of the initial subpoena served on PSI by government investigators in 2012. Under a reservation of rights, Starr thereafter reimbursed PSI for $670,000 in defense costs incurred in responding to the investigation even though no formal criminal prosecution had been instituted.19

After the guilty pleas were entered in March 2013, PSI sought reimbursement of additional defense costs from Starr, but Starr refused on the grounds that the D&O policy's exclusions had been triggered by admissions made in the PSI officers' guilty pleas. PSI then filed suit seeking reimbursement for the outstanding defense costs. Starr counterclaimed against PSI, asserting that it was entitled to recoupment of the $670,000 it had advanced because exclusions had been triggered to bar coverage for all claims under the D&O policy.20

Starr asserted that the D&O policy's Profit and Fraud Exclusions applied because of the PSI officers' guilty pleas. The Profit Exclusion barred coverage for claims arising out of "gaining of any profit or advantage or improper or illegal remuneration if a final judgment or adjudication establishes that such Insured was not legally entitled to such profit or advantage or that such remuneration was improper or illegal." The Fraud Exclusion removed coverage for "any deliberate or fraudulent act or any willful violation of law by an Insured if a final judgment or adjudication establishes that such act or violation occurred."21

PSI did not aggressively deny that the Profit and Fraud Exclusions were triggered by the officers' guilty pleas and the judgment entered against them. However, PSI contended that the Exclusions could only apply to defense costs incurred (and for which PSI sought reimbursement from Starr) after the guilty pleas had been entered in March 2013. PSI thus argued that the Exclusions had no effect on coverage from the initiation of the government's investigation in 2012 through entry of the guilty pleas in March 2013, so that there was coverage under the D&O policy for the defense costs advanced by PSI during that period. PSI also reasoned that the Profit and Fraud Exclusions became effective only upon entry of the pleas in March 2013, and only those defense costs incurred by PSI after March 2013 were not covered.22

The Protection Strategies court disagreed with PSI, finding that the Profit and Fraud Exclusions were triggered by a "final judgment or adjudication" so that Starr should not have paid any defense costs whatsover. The court found the D&O policy's language stating that it "shall not cover any Loss" falling within an exclusion meant that any and all loss, including defense costs, was excluded from coverage regardless of the timing of the "final adjudication."23 According to the court, PSI's "narrow" reading of the Profit and Fraud Exclusions would require Starr to cover "potentially staggering losses" (such as the $670,000 in defense costs advanced by Starr) that are excluded from coverage without the possibility of recoupment, presumably because "final" judgment or adjudication could not take place until the end of an enforcement action.24

In seeking recoupment of the advanced defense costs, Starr relied on a policy condition which stated that, "to the extent that the Insureds shall not be entitled to payment of such Loss under the terms and conditions of this policy, such payments by [Starr] shall be repaid to [Starr] by the Insureds."25 PSI objected on the grounds that recoupment is a "categorically inappropriate remedy" in a duty to defend policy.26

The court again disagreed with PSI. The Protection Strategies court pointed to what it described as "many" decisions from several jurisdictions holding that an insurer can recoup defense costs where its policy contains a clear and unambiguous written recoupment provision.27 Because the D&O policy expressly required PSI to repay defense costs advanced by Starr if the claims were found to be excluded, the court ruled, Starr could recoup its $670,000 from PSI.


Settlements with regulatory agencies pose a multitude of issues that can impact D&O coverage. The J.P. Morgan decision demonstrates that insureds and insurers must carefully analyze orders entered by regulatory agencies as part of a settlement of regulatory actions. Practitioners should keep in mind that the SEC in particular makes very detailed findings in its administrative settlements setting out its view of the target's wrongdoing which may be used by the insurer (as well as future litigants in separate actions) to claim that the target's fraudulent conduct has been finally decided.

This is in contrast to other proceedings (such as SEC injunctive actions) where the agency only makes allegations as to the target's conduct.

Practitioners should also be aware D&O policies almost always contain recoupment provisions so that defense costs advanced to the insured may, in some circumstances, have to be paid back to the insurer if there is a "final adjudication" of the insured's excluded conduct. As the Protection Strategies court held, the timing of the final adjudication of excluded conduct may not affect the insurer's right to recoup all of the defense costs it has advanced. Most of the focus in these settlements is justifiably on amounts paid to settle the actions and buy the insured peace.

However, the insurer's right to recoupment may multiply the insured's potential out-of-pocket costs in achieving that result. The specific policy provisions should be closely reviewed to determine when and how the insurer can exercise its right to such recoupment.


1. See, e.g., SEC Enforcement Actions: Addressing Misconduct That Led To or Arose From the Financial Crisis (modified 12/12/2013) (found at

2. See, e.g., Option Resource Group v. Chambers Dev. Co., 967 F. Supp. 846 (W.D. Pa. 1996), [enhanced version available to subscribers].

3. 42 Misc. 3d 1230(A), 2014 N.Y. Slip Op. 50284(U) (Feb. 28, 2014), [enhanced version available to subscribers]. The case had previously been on appeal on the issue of whether the D&O policy at issue covered the disgorgement of profits that Bear Stearns agreed to under the settlement agreement with the SEC, or whether such coverage was barred as a matter of public policy. See J.P. Morgan Securities, Inc. v. Vigilant Ins. Co., 21 N.Y.3d 324, 992 N.E.2d 1076 (N.Y. 2013), [enhanced version available to subscribers]. The New York Court of Appeals held that coverage for disgorgement would not violate New York public policy. Id.

4. Id. at *1.

5. A Wells notice is a letter sent by the SEC to targets of investigations notifying them that the SEC may bring an enforcement action against them. A Wells submission is the target's response to the SEC setting forth the reasons why no such action is appropriate.

6. Id.

7. Id.

8. J.P. Morgan, 21 N.Y.3d at 331. The SEC also found that Bear Stearns "willfully" violated provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934. Id.

9. Id. at *1.

10. Id. at *2 (emphasis added).

11. Id. at *3

12. Id. at *3-4.

13. Id. at *3-4 (citing National Union Fire Ins. Co. of Pittsburgh, Pa. v. Xerox Corp., 792 N.Y.S.2d 772 (N.Y. Sup. Ct. 2004), [enhanced version available to subscribers], aff'd 807 N.Y.S.2d 344 (1st Dep't 2006), [enhanced version available to subscribers].

14. Id. at *4 (citing Lipsky v. Commonwealth United Corp., 551 F.2d 887 (2d Cir. 1976), [enhanced version available to subscribers].

15. 2014 U.S. Dist. LEXIS 56652 (E.D. Va. Apr. 23, 2014), [enhanced version available to subscribers].

16. Id. at *3-4.

17. Id. at *4.

18. Id. at *6-7, 15.

19. Id. at *5-6.

20. Id. at *6-7.

21. Id. at *15-16 (emphasis added).

22. Id. at *16-19.

23. Id. at *18.

24. Id. at *18-19.

25. Id. at *23-24 (emphasis added).

26. Id. at *24.

27. Id. at *8 (citing Huntsman Advanced Materials LLC v. OneBeacon America Ins. Co., 2012 U.S. Dist. LEXIS 19053 (D. Idaho, Feb. 12, 2012) (Idaho law), [enhanced version available to subscribers]; American & Foreign Ins. Co. v. Jerry's Sport Center, Inc., 2 A.3d 526 (Pa. 2010), [enhanced version available to subscribers]; Medical Liability Mut. Ins. Co. v. Alan Curtis Enterprises, Inc., 285 S.W.3d 233 (Ark. 2008)), [enhanced version available to subscribers]. The court noted that there was a split among courts about whether an insurer's right to recoupment of defense costs exists where no written recoupment provision is in the policy, and the insurer relies only on the contents of its reservation of rights letter setting out its right to recoupment. Id. at *9 (citing ABT Building Products Corp. v. Nat'l Union Fire Ins. Co. of Pittsburgh, 472 F.3d 99 (4th Cir. 2006)), [enhanced version available to subscribers].

Gregory J. May is a partner in the Boston office of the law firm of Nelson Mullins Riley & Scarborough LLP. He advises and represents clients on a variety of insurance issues, including directors and officers liability matters. Any commentary or opinions do not reflect the opinions of Nelson Mullins or Mealey's Publications. Copyright (c) 2014 by Gregory J. May. Responses are welcome.

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