Court Rules Certain Securities Claims Uninsurable Despite Presence of Director and Officer Insurance Policy

Must an insurer reimburse funds spent by an insured to settle a Securities Act of 1933 § 11 (false registration statement) claim where the litigants agreed no part of the settlement was for disgorgement of profits and where the insurance policy expressly covers securities claims except for "disgorged" profits? Contrary to a careful reading of the 1933 Act and most D&O policies, last year a federal court, in CNL Hotels and Resorts, Inc. v. Twin City Fire Insurance Co., 505 F. Supp. 2d 1317 (M.D. Fla. 2007), aff'd in part, rev'd in part, 2008 WL 3823898 (11th Cir. 2008), following a similar unpublished Indiana state court decision, held an insured's § 11 settlement payment was not covered under the circumstances described above. The insured appealed, and on August 18, 2008, the Eleventh Circuit Court of Appeals affirmed that portion of the district court's ruling, stating, "Section 11 does not preclude restitutionary relief" and finding the settlement of the securities claim was not a "loss" under the D&O policy. CNL Hotels & Resorts, Inc. v. Twin City Fire Ins. Co., No. 07-12706, 2008 WL 3823898, at *2-*3 (11th Cir. Aug. 18, 2008) (per curiam) (unpublished).

Origins of the Argument Against Coverage

The genesis of the insurer's argument in support of denying coverage for § 11 securities claims first arose in 2003, after an Indiana state circuit court judge, in Conseco, Inc. v. National Union Fire Insurance Co., No. 49D130202CP000348, 2002 WL 31961447 (Ind. Cir. Ct. Dec. 31, 2002) (unpublished), granted excess insurer Lloyd's motion to dismiss the complaint of Conseco, who had sued Lloyd's under a D&O policy to recover funds paid to settle a § 11 claim. The plaintiffs in the underlying securities litigation had alleged Conseco misrepresented its financial strength in violation of § 10 of the Securities Exchange Act of 1934 and included misstatements in its registration statements in violation of § 11 and in its prospectus in violation of § 12 of the 1933 Act. The plaintiffs alleged the § 10 violation led to the stock price's decline when the true finances were revealed and that the § 11 and § 12 misstatements led to an inflated offering price. Conseco settled the § 10 claims for $38 million and settled the § 11 claims for $81 million.

The definition of "loss" in the D&O policy at issue included damages, settlements, judgments, and defense costs. The policy expressly covered "the Loss of the Company arising from a . . . Securities Claim." Id. at *6. But the Conseco court, applying Indiana law, held no "loss" had occurred because the policy excluded uninsurable matters from the definition of "loss," and, according to the court, the payment made to settle the § 11 claims was uninsurable because it disgorged funds wrongfully acquired by Conseco when it offered securities at an inflated price due to misrepresentations in the registration statement. Id. at *6-*7. The court declared § 11 and § 12 claims to be "restitutionary in character," citing the legislative history and text of both sections. Id. at *8-*10.

CNL Hotels

Trial Court Ruling

Perhaps spurred on by the Conseco decision, some insurance companies have argued the term "loss" does not include § 11 damages. In CNL Hotels, the insurers argued CNL Hotels's settlement of § 11 claims "represented a type of disgorgement, rather than an actual loss" which was not insurable. 505 F. Supp. 2d at 1318-19. In the underlying § 11 securities litigation, the plaintiffs sought to recover an $8 per share difference between the offering price of $20 per share and the expert-calculated actual value of $12 per share. Id. at 1326. CNL Hotels ultimately settled the claims for $35 million. Id. at 1318.

The D&O policy in CNL Hotels expressly provided coverage for securities claims under the Securities Act of 1933 and the Securities Exchange Act of 1934. Further, the settlement agreement expressly stated no part of the settlement represented "restitution or disgorgement" or return of "ill-gotten gains." Nonetheless, the CNL Hotels court granted motions for partial summary judgment by the insurers. The trial court, citing New York and Florida law, stated that while "[§] 11 claims are not per se uninsurable," id. at 1324-25, "[r]egardless of the statute under which the original claim is asserted, and regardless of whether the policy references that statute, if the insured is simply being forced to return money to which it was not entitled, the event is not a loss," id. at 1324. The court stated a party may not insure itself against the risk of having to return ill-gotten gains and concluded the appropriate analysis was not to examine the elements of the claim settled or whether fraud was alleged but to determine if the amount paid to the security purchasers represented the return of stolen property. Id. at 1323.

Eleventh Circuit Affirmance

The Eleventh Circuit affirmed the district court's ruling that the settlement of the claim brought by the purchasers of the securities was not a "loss." CNL Hotels, 2008 WL 3823898, at *5 (affirming in part and reversing in part). The appellate court adopted the principle that "a ‘loss' within the meaning of an insurance contract does not include the restoration of ill-gotten gains." Id. at *2 (quoting Level 3 Commc'ns, Inc. v. Fed. Ins. Co., 272 F.3d 908, 910 (7th Cir. 2001)). The court found that "[t]he return of money received through a violation of law, even if the actions of the recipient were innocent, constitutes a restitutionary payment." Id. at *3.

The appellate court rejected CNL's argument that § 11 damages cannot be restitutionary because the statute limits the purchaser's damages—where the shares have been resold by the time of the judgment or settlement—to the difference between the security's purchase price and the sale price. Id. The court found, "the loss to the plaintiff [wa]s equal to the gain of the defendant," because CNL did not dispute that the plaintiffs alleged they had "purchased shares from CNL for $20 a share when the shares were actually worth only $12 a share." Id. Finally, the court rejected CNL's reliance on the characterization of the payment made by CNL as set forth in the settlement agreement, noting the agreement was "not binding on any third party or this Court." Id.

Arguments in Response to Denial of Coverage

It remains to be seen whether the Eleventh Circuit's sister circuits will follow the CNL Hotel decision. Fortunately for D&O policyholders, significant flaws exist in the reasoning of the Conseco and CNL Hotels decisions, which should be highlighted where an insurer attempts to evade coverage.

First, while it is true that damages incurred for intentional violations of securities laws are often uninsurable losses as a matter of public policy, § 11 and § 12 of the 1933 Act hold corporations strictly liable for unintentional securities law violations, and the Act provides only limited defenses to directors and officers. See 15 U.S.C. §§ 77k(a)-(b); 77l(a). Thus, there is no public policy basis for holding § 11 or § 12 claims uninsurable as a matter of law.

Second, § 11 limits the purchaser's damages, where the shares have been resold by the time of the judgment or settlement, to the difference between the security's purchase price and the sale price. See § 77k(e)(3), (g). And despite the Eleventh Circuit's holding, both § 11 and § 12 expressly limit the purchaser's recovery to the loss actually caused by the misstatements or omissions identified (i.e., the substantial decline in the value of the securities), demonstrating the intent of both statutes is to allow recovery of the economic loss to the purchaser—not restitution. See §§ 77k(e); 77l(b).

Third, the characterization of § 11 or § 12 damages or settlements as restitutionary is questionable since, in most public offerings, it is the company, not its directors or officers, who reaps the reward of the sale. Thus, the settlement of claims is not a return of monies received by directors and officers. See Jonathan C. Dickey, Securities Litigation § 14:2.4 (2006).

Finally, the Conseco and CNL Hotels courts' analyses rely heavily on the dictum discussion of restitutionary securities claims found in an inapposite opinion from the U.S. Court of Appeals for the Seventh Circuit, Level 3 Communications, Inc. v. Federal Insurance Co., 272 F.3d 908 (7th Cir. 2001). See 26A Michael J. Kaufman, Securities Litigation: Damages § 20:28 (2007) (recounting how the securities suit in Level 3 was brought by the sellers of securities who claimed the buyer stole the securities and discussing why § 11 and §12 claims are not available to sellers of securities).

Preventative Measures

Despite the flaws in the legal analysis of the Conseco and CNL Hotel decisions, the Eleventh Circuit's recent affirmance indicates caution is warranted in resolving suits which allege § 11 violations. The average securities case settlement is for more than $40 million and about twenty percent of D&O settlements involve § 11 and § 12(a)(2) claims. See Laura E. Simmons & Ellen M. Ryan, Securities Class Action Settlements: 2006 Review and Analysis (Cornerstone Research report). Hence, companies should examine their D&O policies closely and seek the inclusion of language which would prevent insurers from raising the Conseco uninsurability argument.

In the wake of Conseco, most D&O insurers now offer an endorsement which clarifies that § 11 and § 12 are insured losses. For example, American International Group (AIG) offers an endorsement which clarifies that while a "loss" does not include "matters which may be deemed uninsurable under the law," the insurer:

Additionally, insureds should take into account the Conseco and CNL Hotels cases, especially when drafting settlement agreements where 1933 and 1934 Act claims are both in the mix. The size of the settlement and if and how the settlement payments are compartmentalized by type of claim may affect the result in any subsequent coverage dispute. Insurers who raise the Conseco uninsurability argument may point to the settlement agreement for support in arguing certain payments were restitutionary in character. See David C. Parisi, Directors and Officers Liability Claims, J. Consumer Attys. Ass'ns S. Cal., Aug. 2007. Courts may also review the size of the settlement in determining whether the settlement represents the return of ill-gotten gains or the disposal of a nuisance suit. See id.

Finally, insureds should keep in mind that where the Eleventh Circuit's affirmance guides the resolution of suits which allege § 11 violations, insureds may not be able to claim attorneys fees as part of a loss. In CNL Hotels, CNL argued the $7 million awarded to the attorneys in the underlying class action securities case (twenty percent of the settlement amount) should not constitute restitution. 505 F. Supp. 2d at 1326 n.12. But the trial court rejected this argument, stating, "The $7 million was a part of the sum that CNL disgorged to settle the Section 11 claims in the Class Action. The fact that the plaintiffs had to use some of that money to pay their attorneys does not alter the character of CNL's payment, which was clearly restitutionary." Id.