January 31, 2012

Navigating a Mine Field: Governmental Investigations, Cooperation, and D&O Insurance

In the investigations arena, there are countless ways for the government to seek information from both corporations and individuals, and countless government entities--local, state, and federal--with different powers that can be involved. While the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) are two primary enforcement bodies, almost every government agency that regulates business has some form of authority to request information and ask questions. And, each state has its own office of attorney general or similar office as well as various administrative agencies with investigative and subpoena power. There is no shortage of mechanisms for the government to seek the information that it believes it needs or is entitled to receive.

Regardless of the nature of the government inquiry, it is almost a foregone conclusion that legal counsel and other consultants will be involved in the corporation's response. This is true even if a corporation chooses to cooperate with the government's investigation. As the government has adopted policies which are designed to encourage a corporation's cooperation, there are strong incentives to cooperate. Indeed, cooperation is often critical to both the SEC's decision to pursue enforcement and the DOJ's decision whether to prosecute.

The legal fees and costs associated with responding--and cooperating--can be substantial. In order to mitigate these fees and costs, corporations have turned to their directors and officers' liability insurance policy (D&O policy) for reimbursement of such fees and costs. This, in turn, can lead to coverage disputes between insureds and their insurers. Indeed, two of the most notable D&O insurance decisions from the past year arose out of such disputes. In Office Depot Inc. v. National Union Fire Ins. Co., 2011 WL 4840951 (11th Cir. (Fla.)), the Eleventh Circuit held that the applicable D&O policy did not provide coverage for the $23 million in attorneys' fees Office Depot incurred to defend against an SEC investigation, conduct an internal audit, or indemnify its directors and officers prior to their receipt of a subpoena or Wells Notice. In contrast, in MBIA, Inc. v. Federal Ins. Co., 2011 WL 2583080 (2nd Cir. (N.Y.)), the Second Circuit held that the applicable D&O policy provided coverage for the a series of investigations even though the insured had cooperated voluntarily and not required a subpoena, the work of a special litigation committee relating to a derivative action, and an independent consultant retained in conjunction with a settlement proposal.

These two decisions--Office Depot and MBIA--are often cited by insurers and policyholders, respectively, as authority for their positions regarding the availability (or not) of coverage for governmental investigations. While at first blush the decisions may appear to be irreconcilable, for the most part, the different outcome turns on varying facts and policy language. Nevertheless, the recent decisions in Office Depot and MBIA illustrate the importance of analyzing and understanding what coverage a corporation may--or may not--have in place for government investigations. These decisions also illustrate the implications an insured faces when it decides to cooperate with regulators conducting governmental investigations. As such, before discussing the Office Depot and MBIA decisions, it is necessary to first understand the reasoning behind such cooperation by an insured.

Cooperation with Government Agencies

Both the SEC and DOJ consider cooperation as a mitigating factor when deciding to prosecute a case or levy sanctions, however, neither guarantee leniency. For example, in its 2010 Enforcement Manual, the SEC stated that it would consider, in part, the following factors when evaluating action against a cooperating corporation:

  • Self-reporting of misconduct when it is discovered, including conducting a thorough review of the nature, extent, origins and consequences of the misconduct, and promptly, completely, and effectively disclosing the misconduct to the public, to regulatory agencies, and to self-regulatory organizations;
  • Remediation, including dismissing or appropriately disciplining wrongdoers, modifying and improving internal controls and procedures to prevent recurrence of the misconduct, and appropriately compensating those adversely affected; and
  • Cooperation with law enforcement authorities, including providing the commission staff with all information relevant to the underlying violations and the corporation's remedial efforts.

See S.E.C. Enforcement Manual, Framework for Evaluating Cooperation by Companies 6.1.2 (Jan. 13, 2010). Likewise, the DOJ recommends that prosecutors consider, in part, the following factors when contemplating indictment of a corporation:

  • The corporation's timely and voluntary disclosure of wrongdoing and its willingness to cooperate in the investigation of its agents; and
  • The corporation's remedial actions, including any efforts to implement an effective corporate compliance program or to improve an existing one, to replace responsible management, to discipline or terminate wrongdoers, to pay restitution, and to cooperate with the relevant government agencies.

See U.S. Attorney's Manual: Principles of Federal Prosecution of Business Organizations, factors to be considered 9-28.300 (2010).

However, cooperation like that envisioned by the SEC and DOJ is not cheap. If an internal investigation is called for by a whistleblower complaint or other notification to the company, it generally must be performed by outside counsel, who will then determine whether self-reporting to the government is necessary. Depending on the issue, assistance from non-legal consultants or experts (such as accountants or forensic specialists) may be required for the investigation. Moreover, the list of counsel involved in an investigation is rarely limited to one law firm retained by the corporation. Often, individual directors, officers and employees will request--rightfully so--their own separate counsel. This is particularly true if the SEC asks for so-called "voluntary" interviews, which are frequently conducted under oath and subject to the penalties of perjury. As the investigation continues, other employees may be called upon to testify, and it may be prudent for the corporation to provide them with their own counsel (at the corporation's expense) to ensure that their rights are protected. In addition, many of these individuals will be entitled to indemnification under employment agreements or corporation charters or by-laws. Where such indemnification is not mandatory, the corporation may still deem it advisable to provide it.

Not surprisingly, the cost of cooperating with the SEC and DOJ may far exceed the sanctions ultimately imposed upon the corporation. For example, Office Depot spent over $23 million to defend against allegations that it and two of its officers violated the section 13(a) of the Securities and Exchange Act of 1933 and Regulation FD. These allegations were resolved when Office Depot agreed to pay a civil penalty in the amount of $1 million and two of its officers agreed to pay $50,000 each. Illustrating the significance the SEC places on cooperation, when considering settlement, the SEC expressly considered the remedial acts taken by Office Depot and the cooperation it afforded to the SEC during the investigation. SeeIn the Matter of Office Depot, SEC Release No. 63,152, 2010 WL 4135029, at *7 (Oct. 21, 2010) ("In determining to accept the Offer, the Commission considered remedial acts promptly undertaken by Respondent and cooperation afforded the Commission staff.")

The Office Depot Decision

Shortly after a "Dow Jones Newswire" article reported that Office Depot may have improperly disclosed material information, the SEC in July of 2007 issued a letter to Office Depot advising it that it was conducting an inquiry in order to determine whether Office Depot had violated securities laws. In the letter, the SEC requested certain information from Office Depot on a "voluntary" basis. Office Depot agreed to voluntarily cooperate with the SEC by providing documents and also making its officers and employees available for sworn testimony without the issuance of a subpoena. Office Depot notified its insurer of both the Dow Jones article and the SEC's letter.

Prior to receiving the July 2007 letter from the SEC, Office Depot received an internal whistleblower letter alleging various accounting irregularities. In response, the Office Depot Audit Committee conducted--with the assistance of attorneys, accountants, and consultants--an internal review and investigation. After conducting its internal review, Office Depot restated certain financial statements and self-reported the issues that were the subject of the restatement to the SEC. At that time, the SEC expanded its inquiry to examine the purported accounting irregularities referenced in the whistleblower letter.

In January of 2008, the SEC issued a formal order of investigation, and, over the course of the following year, issued a series of subpoenas to Office Depot and numerous current and former employees. In addition, the SEC issued Wells Notices to three officers of Office Depot, explaining that the SEC intended to recommend that enforcement proceedings be instituted against them. In December of 2009, the SEC, Office Depot and two of its officers reached a settlement.

Office Depot sought coverage under its D&O policy for the legal fees and costs it incurred in connection with the SEC investigation and internal audit. The insurer rejected Office Depot's request for coverage on the grounds that the policy did not afford coverage to Office Depot for SEC investigations or internal audits. As for Office Depot's indemnity obligations to its directors and officers, the insurer agreed to reimburse Office Depot for the attorneys' fees the directors and officers incurred after they received a subpoena or Wells Notice from the SEC. However, the insurer declined to reimburse Office Depot for any attorneys' fees incurred prior to that time.

Office Depot filed a lawsuit challenging the insurer's denial of coverage for the SEC investigation, internal audit, and pre-subpoena and Wells Notice legal fees and costs. A federal district court agreed with the insurer, finding that the D&O policy--as negotiated and issued--did not provide coverage to Office Depot for legal fees and costs incurred to respond to the SEC's investigation or to indemnify its directors and officers prior to their receipt of either a subpoena or Wells Notice. Last fall, the Eleventh Circuit affirmed the decision.

As a general rule, to be afforded coverage under a D&O policy, there must first be a claim. As such, an understanding of the Office Depot decision first requires an examination of the D&O policy's definition of the term "claim." The Office Depot D&O policy defined a "claim" to include, among other things a civil, criminal, or administrative or regulatory investigation of a director or officer: (1) once that director or officer is identified in writing as being a person against whom a proceeding may be commenced; or (2) in the case of an SEC investigation, after service of a subpoena. Notably, the policy was silent as to whether a claim included a civil, criminal, or administrative or regulatory investigation of Office Depot itself.

The D&O policy also provided that a claim included any "securities claim," which was in turn defined to include claims alleging violation of federal, state, or local securities laws or regulations. Importantly, the D&O policy expressly provided that a securities claim did not include an administrative or regulatory proceeding against or investigation of Office Depot. The policy did, however, contain a carve-back restoring coverage for administrative or regulatory proceedings against Office Depot in certain specified situations. The carve-back did not reference or otherwise mention investigations.

Because the policy's definition of a claim did not include SEC investigations of Office Depot, the Eleventh Circuit held that the D&O policy did not provide coverage to Office Depot in connection with any such investigation. In so holding, the court rejected Office Depot's assertion that policy's definition of "claim" was ambiguous, circular, and confusing due to cross-references between claim and securities claim. The Eleventh Circuit also rejected Office Depot's more technical argument that the carve-back applied because a "proceeding" necessarily included a formal investigation by the SEC. Focusing on the insurer's use of the terms "proceeding" and "investigation," the court explained that, because each phrase has meaning, the omission of "administrative or regulatory investigation" in the carveback was dispositive.

As for the directors and officers, Office Depot asserted that, because it provided notice of a potential claim in July of 2007, any subsequent claim related back to the July 2007 notice. According to Office Depot, this meant that all legal fees and costs incurred from July 2007 forward were covered. The Eleventh Circuit rejected this argument explaining that nothing in the policy language indicates that coverage is extended to defense costs incurred after a notice is filed but before a claim exists. The Eleventh Circuit also rejected a similar argument that, because the policy does not include a temporal limitation barring coverage for pre-claim expenses, there is coverage for the costs of investigating an anticipated claim.

The MBIA Decision

In March of 2001, the SEC issued a formal order of investigation into certain accounting practices in the insurance industry. The order initiated an investigation into companies' compliance with securities laws, their financial recordkeeping, financial reporting, and related matters. Pursuant to that investigation, in November of 2004, the SEC issued a subpoena to MBIA to produce all documents concerning transactions involving "non-traditional products." Shortly thereafter, the New York attorney general (NYAG) issued a virtually identical subpoena to MBIA. The MBIA produced documents to both regulators.

Ultimately, three of MBIA's transactions were scrutinized. The first related to its purchase of reinsurance on its guarantee of bonds issued by a hospital group owned by AHERF (Allegheny Health, Education and Research Foundation). During the SEC's investigation into the AHERF transaction, it began to investigate transactions relating to Capital Asset and US Airways. In the summer of 2005, the SEC and NYAG informed MBIA that was considering issuing additional subpoenas. To avoid further public relations issues, MBIA asked the regulators whether MBIA could voluntarily comply with the document requests. The regulators agreed and MBIA produced documents relating to the Capital Asset and US Airways transactions.

MBIA settled with the SEC and the NYAG for the AHERF transaction. When MBIA sought consent to settle the AHERF transaction from its insurers, the insurer explained that it did not believe that any such settlement was covered but, it agreed not to raise "lack of consent" as a defense to coverage. Meanwhile, because the investigation into the Capital Asset and US Airways transactions was not complete, to allow the AHERF settlement to proceed, the parties agreed that, at MBIA's expense, an independent consultant would be retained to investigate those transactions. The insurer was not informed of the retention of the independent consultant until after his work was underway, nor did MBIA seek consent for the retention of the independent consultant. Ultimately, the independent consultant exonerated MBIA of any wrongdoing in for both the Capital Asset and US Airways transactions.

Meanwhile, as a result of the governmental investigations, lawsuits were filed against MBIA. Prior to filing suit, shareholder demand letters were sent to MBIA asking for the board to file suit against the directors and officers for the alleged wrongdoing. In response, MBIA set up a demand investigation committee (DIC) to investigate the demands. After MBIA did not act on the demands, two derivative lawsuits were filed. MBIA then reconstituted the DIC as a special litigation committee (SLC) to evaluate whether the lawsuits were in the best interests of MBIA. The SLC concluded, after an investigation by outside counsel, that they were not and, relying upon Connecticut statutory law, filed a motion to dismiss. The lawsuits were subsequently voluntarily dismissed.

While the insurer paid for the defense expenses related to the SEC's AHERF investigation under the policy's formal investigations coverage, it denied coverage for costs and expenses incurred for (1) the parallel investigation into the AHERF transaction by the NYAG; and (2) the Capital Asset and US Airways investigations. In addition, the insurer denied coverage for the work of the SLC and the independent consultant. According to the insurer, it was a temporal coincidence that the SEC was investigating the Capital Asset and US Airways transactions at the same time as the AHERF formal investigation. As for the NYAG's investigation, the insurer maintained that, because the NYAG had not issued a formal order of notice or investigation, the subpoena was not the subject of a formal order or notice and thus not covered.

Thereafter, MBIA filed suit against the insurer seeking coverage for (1) the costs and expenses relating to all three transactions; (2) the fees incurred for the independent consultant's work; and (3) the SLC's work. The district court granted summary judgment in favor of MBIA regarding the investigations and the SLC work and against MBIA for the independent consultant costs. On appeal, the Second Circuit found that all three categories of expenses were covered.

The MBIA policy defined a securities claim to include "a formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document." The Second Circuit agreed with MBIA that the two additional investigations fell under the broad formal investigative order issued by the SEC in March of 2001. As for the NYAG subpoenas, the Second Circuit found that the subpoenas constituted a "securities claim" because they were similar to other forms of investigative demands made by regulators and because a businessperson would certainly deem the subpoenas to be similar to an investigative order. In so doing, the Second Circuit rejected the insurer's argument that, because MBIA voluntarily agreed to produce the documents in response to an oral request, the investigations were not covered.

The Second Circuit also held that there the policy afforded coverage for an independent consultant's investigation and the work of an SLC. With respect to the independent consultant, the Second Circuit discussed at length the policy's right to associate and consent to settle provisions in the D&O policy. Reversing the district court, the Second Circuit found that, because the insurer declined to participate in the settlement negotiations, it cannot argue that it was somehow denied its "right to associate" under the policy. As for the consent to settle, the insurer argued that, while is agreed not to raise lack of consent regarding resolution of the AHERF investigation, it did not agree to the retention of an independent consultant for the Capital Asset or US Airways transactions. The Second Circuit disagreed finding that the settlement grew out of a single course of settlement discussions. The Second Circuit also found it compelling that, while the insurer was notified of the independent consultant prior to the final proposed offer of settlement (although after his work was concluded), it never raised any objection to the independent consultant. In so holding, the Second Circuit essentially rejected as irrelevant the fact that the independent consultant had been evaluating MBIA for at least four months before the insurers were informed.

As for the SLC, the Second Circuit found that the work by the SLC was covered under the policy as an "insured person" because MBIA was exercising its powers through the SLC. While the insurer argued that the shareholder derivative sublimit effectively operated as an exclusion for such coverage in excess of the sublimit, the Second Circuit rejected that argument finding that the policy lacked any language providing for such a result.

Reconciling Office Depot and MBIA

The Office Depot and MBIA decisions are an important reminder for insureds and their insurers that every investigative tool at the government's disposal, and every potential corporation response that gives rise to legal fees and costs, does not fit neatly into many insurance policies' definition of a claim or securities claim. Many investigations are conducted internally or informally, at least at the outset, and even those early stages can result in significant legal and other expenses. This is particularly true when a corporation elects to cooperate with a government agency. However, many D&O policies, such as the one in Office Depot and MBIA, do not provide coverage to a corporation or its directors and officers for such internal or informal agency investigations.

Indeed, in contrast to the more traditional property and casualty lines of insurance, D&O policies are heavily manuscripted and coverage can vary widely from policy to policy and insurer to insurer. As Office Depot and MBIA illustrate, this is particularly true in the investigations context. For example, the policy issued to MBIA--unlike the policy issued to Office Depot--provided coverage for formal investigations against the entity. In addition, the facts in both cases were different. While MBIA voluntarily produced documents, a formal investigative order had already been issued. Thus, the issuance of a subpoena was a mere formality. In contrast, a formal order of investigation had not been issued when Office Depot was cooperating with the regulators. Thus, while both insurers and insureds may rely upon Office Depot or MBIA for their respective coverage positions, the decisions can be reconciled based upon the facts of each case, including the stage of the governmental investigation, and the applicable policy language.

Regardless, the D&O marketplace is constantly changing with new products becoming available to provide coverage where none existed before. Office Depot and MBIA thus underscore the importance for insureds and insurers to retain skilled counsel to carefully examine the proposed policy language before a claim is made, during the negotiation process, and in the event the language does not conform to the intent of the insured or insurer, the policy should be modified. While such modification result may (or may not) be favorable to the insureds or the insurers, changes in contractual language should occur prior to the issuance of the policy; it should not be the result of judicial fiat.