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