January 03, 2014 Articles

Navigating Insurance Minefields in SEC Enforcement-Action Settlements

Two recent shifts will test even state-of-the-art directors' and officers' policies

By Eric G. Barber and Charles W. Mulaney

Two recent shifts in policy by the Securities and Exchange Commission (SEC) will test even state-of-the-art directors’ and officers’ (D&O) insurance policies and will require those negotiating settlements with the SEC to have a firm grasp of the operation of some key D&O insurance provisions. First, in June 2013, SEC Chair Mary Jo White announced that the SEC may not enter into no-admit-no-deny settlements in cases involving “widespread harm to investors” or “egregious intentional misconduct.” This is a deviation from the policy of not requiring admissions of wrongdoing unless there was an underlying criminal conviction. The JPMorgan “London Whale” and Philip Falcone-Harbinger Capital settlements confirm that the SEC will follow this policy with future settlements. The second shift—and equally important for D&O insurance issues—was announced by White on September 26, 2013. This slightly more subtle shift will have the SEC pursuing more enforcement actions against individuals in an effort to deter future violations of the law. These two policy shifts may have a serious impact on companies’ and individuals’ ability to tap into their D&O insurance policies for the defense of enforcement actions and civil litigation.

This article gives a brief overview of recent settlements with the SEC and highlights the key provisions every director, officer, and their counsel should examine during policy renewal and before settling an enforcement action with the SEC or any other federal or state regulator where an admission of wrongdoing is sought.


Recent Settlements of SEC Enforcement Actions
In two high-profile cases, the SEC has required admissions of wrongdoing as a condition of settling its enforcement actions. JPMorgan Chase will pay over $900 million to resolve some, but not all, of the pending regulatory enforcement actions it has been facing. Jessica Silver-Greenberg & Ben Protess, “JPMorgan Set to Pay More Than $900 Million in Fines,” N.Y. Times Dealbook, Sept. 18, 2013. JPMorgan also admitted wrongdoing in connection with its settlement with the SEC. Readers interested in examining all of the admissions can find them here in the SEC order, but for purposes of this article, two points should be made. First, the admissions are not made on behalf of any single individual. For example, “JPMorgan Senior Management” is defined to include one or more of five different executives. Second, because the settlement negotiations took place in an administrative proceeding, court approval is not needed; therefore, JPMorgan was allowed to avoid “specific admissions or more direct admissions of individual wrongdoing.” Kevin LaCroix, “A Closer Look at JPMorgan’s $920 Million ‘London Whale’ Regulatory Settlements,” D&O Diary, Sept. 20, 2013. The SEC’s policy has also been adopted by other governmental agencies. The Wall Street Journal reported that the Department of Justice and New York Attorney General were insisting on an admission of guilt in negotiations regarding JPMorgan’s settlement of mortgage fraud allegations. “Looting J. P. Morgan, Again,” Wall St. J., Oct. 3, 2013.


The other noteworthy settlement with the SEC involved two enforcement actions against billionaire Philip Falcone and his hedge fund, Harbinger Capital Partners. Nos. 12 CIV 5027 (PAC), 12 CIV 5028 (PAC) (S.D.N.Y. Sept. 16, 2013) (final consent judgment). The SEC required Falcone to admit wrongdoing in addition to paying an $18 million penalty after the SEC commissioners rejected an earlier settlement that did not contain an admission of wrongdoing. The SEC alleged that Falcone improperly used $113.2 million of investors’ funds to pay his own taxes, favored some investors’ redemption requests over others’, and improperly traded in bonds.


The SEC’s policy shift illustrated by these recent actions was further clarified by SEC enforcement codirectors Andrew Ceresney and George Canellos when they recently stated that admissions may be in the public interest (1) when misconduct has harmed large numbers of investors or placed investors or the market at risk of potentially serious harm (e.g., JPMorgan, Falcone/Harbinger); (2) when admissions might safeguard against risks posed by the defendant to the investing public, particularly when the defendant engaged in egregious intentional misconduct; or (3) when the defendant engaged in unlawful obstruction of the SEC’s investigative processes.


Many Types of Cases Still Do Not Seem to Qualify for the SEC’s New Approach
Many recent settlements of SEC enforcement actions, which do not appear on their face to involve “widespread investor harm,” have been resolved without an admission of wrongdoing. For example, in early September, a Thai national was permitted to neither admit nor deny the SEC’s allegations against him as part of a $5.2 million settlement stemming from allegations of insider trading in connection with the acquisition of Smithfield Foods. Press Release, SEC, Thailand-Based Trader Agrees to Pay $5.2 Million to Settle Insider Trading Case (Sept. 5, 2013). Attorneys from Perkins Coie’s Chicago office represented the Thai national in this enforcement action.


The SEC does not appear to be requiring admissions in cases linked to mortgage backed securities, although some of these settlement discussions may have started before the SEC’s new settlement policy. For example, in August 2013, UBS was allowed to neither admit nor deny the SEC’s findings related to UBS’s alleged failure to properly structure and market a collateralized debt obligation. In re UBS Secs. LLC, No. 3-15407 (order instituting administrative and cease-and-desist proceedings). And in early November 2013, the SEC announced a $153 million settlement in which it did not require the Royal Bank of Scotland to admit wrongdoing in connection with a $2.2 billion residential mortgage backed security (RMBS) offering. Finally, a Colorado portfolio manager did not admit or deny the SEC’s findings as part of a $355,000 settlement for violations of the Investment Company Act and certain rules promulgated thereunder. In re Carl D. Johns, No. 3-15440 (order instituting administrative and cease-and-desist proceedings).


Navigating the D&O Insurance Minefield
The full effect of the SEC’s new initiatives remains to be seen, but thus far it implicates several different provisions in D&O insurance policies: (1) so-called conduct exclusions; (2) the severability provisions in the policy, including with respect to the application for insurance; and (3) possible repayment of previously advanced defense costs. Before securities defense lawyers negotiate settlements with the SEC, they should have a firm grasp of how these provisions operate and when they are triggered. Even state-of-the-art D&O insurance policies may be tested, so careful attention must be paid to differences in policy language.


As an introductory concept, many D&O insurance policies exclude fines and penalties from the definition of covered “Loss,” and in some jurisdictions there is a general public policy against insuring for illegal or criminal conduct. Therefore, the impact on the scope of coverage for the penalties imposed by government regulators in connection with a settlement will be slight. Rather, the new initiatives’ impact will most likely be felt in connection with insurance coverage for related civil class action lawsuits and on already-advanced defense costs.


Conduct exclusions. All D&O insurance policies contain what are referred to as “conduct exclusions.” These exclusions are meant to carve out from coverage those claims involving deliberate fraudulent or criminal conduct, or the gaining of profit or advantage that is illegal. In their less protective form, a crime/fraud exclusion would exclude coverage based on


the committing of any deliberate fraudulent or deliberate criminal act by the Insured if a judgment, ruling or other finding of fact in any proceeding establishes that such act was committed.


Under this provision, which can still be found in some D&O insurance policies on the market, an insurer might argue that a settlement with the SEC with an admission of intentional or improper conduct is sufficient to trigger this exclusion and thus bar coverage in a civil action arising from the same set of facts. This provision might also allow the insurance company to affirmatively file suit against its insured and use admitted facts from a regulatory settlement to establish that the insured’s claim is not covered. Therefore, the first line of defense is to negotiate a settlement with the SEC that keeps vague who did what wrong (see, for example, the definition of “JPMorgan Senior Management”) and that avoids any mention of intent.


Furthermore, in negotiating conduct exclusions, insureds should insist that the exclusion can only be triggered when the deliberately fraudulent conduct is established by a “final adjudication.” Many modern D&O insurance policies contain language stating that the conduct exclusion can only be triggered “if a final and non-appealable adjudication adverse to such Insured establishes that the Insured so acted.” If the settlement is in the context of an administrative proceeding, such as the JPMorgan settlement, an insured may be able to argue that, absent court approval, the conduct exclusions have not been implicated. In addition, conduct exclusions can be made stronger by requiring that the finding of fact or admission occur in the underlying action (as opposed to an underlying “claim,” which is a broader term than “underlying action” or “proceeding”).


Knowing and understanding the specific language in the conduct exclusions is the first step in effectively negotiating a settlement with any regulator, particularly the SEC.


Severability provisions. D&O insurance policies also often contain what are referred to as “severability provisions.” A general severability provision is first designed to prevent imputation of knowledge or wrongful acts from one individual insured to another for purposes of, for example, invocation of the conduct exclusions. Second, the provision sometimes limits the acts or knowledge of one director or officer from being imputed to the entity so that any fraud exclusion applicable to an individual director or officer does not result in eviscerating coverage for the entity under the policy. Generally, these provisions come into play only when specific individuals are established to have facts or knowledge that would trigger one of the aforementioned conduct exclusions. In many cases, the individuals whose knowledge can be imputed to the entity include the chief executive officer, the chief financial officer, and the general counsel, but some policies are much broader. The import of this provision in negotiating regulatory enforcement-action settlements is obvious.


The second type of severability provision relates to the application for D&O insurance. Although not all companies are required to fill out applications, many do. As part of that application process, an insurer may insist on certain representations and warranties regarding facts or circumstances that may later give rise to a claim. Sometimes “Application” is also defined in the insurance policy to include reporting documents filed with the SEC. These application severability provisions can differ from policy to policy, but well-drafted ones limit relevant knowledge to certain defined individuals, sometimes including only the signer of the application. If it turns out that one of the defined individuals knew material facts prior to the signing of the application, there is an increased risk that a D&O insurer might make a rescission argument with respect to coverage for that individual, the entity, or others, depending on the specific policy’s language. Although some D&O insurance policies do not allow rescission with respect to individual directors and officers under Side-A coverage, there is significant variation among insurance policies on the market.


Repayment of previously advanced defense costs. Finally, insurers may argue that they are entitled to repayment of previously advanced defense costs if a settlement with the SEC contains sufficient specific allegations such that one or more of the conduct exclusions are triggered; thus, the loss is uncovered. Insurers have met with mixed success on this issue, but they were often denied an opportunity to establish a lack of coverage where insureds settle civil cases and regulatory actions without admissions of wrongdoing. Although the likelihood that insurers will pursue previously advanced defense costs remains low, the risk increases in larger cases where millions of dollars have been expended. Attorneys negotiating settlements with the SEC should be careful to understand whether the D&O insurance policy explicitly grants the right to recoupment of previously paid defense costs and whether the insurer explicitly reserved this right when it started making payments.