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In an era marked by the proliferation of corporate fraud litigation, corporations are facing new and unanticipated challenges when they seek to obtain the benefits they thought they had secured when they purchased coverage under directors’ and officers’ liability insurance policies. Understandably, insurers are attempting to limit coverage of losses arising from claims of corporate fraud so that policy proceeds are not expended in the defense of corporate wrongdoers. Insurers have begun denying coverage for settlement payments when the underlying claim can be considered one for restitution. And they are revising D&O policies to make it increasingly difficult for companies to settle cases in which fraud is alleged by putting the burden of proof on the company to establish the absence of fraud. As a result, corporations face the unsettling prospect of attempting to weigh the merits of plaintiffs’ allegations against the potential exposure of litigation while facing uncertainty as to whether the claims will be covered by their D&O policies. D&O policies exist to cover losses that injure the corporate insured. In a standard D&O insurance policy, the term “loss” is often broadly defined to include amounts that corporate directors have paid or are legally obligated to pay as damages, settlements or judgments. Insurance policies ordinarily exclude from coverage judgments against the corporate defendant involving intentional fraudulent conduct. Additionally, companies are discovering that not all settlements fall within the definition of “loss” as stated by their D&O policies. Courts are carving out exceptions that severely limit the coverage that corporate insureds receive in the settlement of federal securities claims. Recent case law has eliminated from coverage damages arising from certain federal securities claims because the company did not experience a loss as defined by state insurance law. Specifically, courts have upheld an insurer’s refusal to reimburse damages, even if paid as the result of a negotiated settlement, by characterizing the claims as the “restitution” of ill-gotten gains. In this changing climate, a naked allegation of fraud can be the basis for an insurer to deny D&O coverage of a settlement that involves no finding of wrongdoing on the part of the corporate insured. The result is that furtherance of the public policy interests advanced by insurance companies is discouraging settlements of federal securities actions and exposing corporate America to substantial liability without any finding of fraudulent conduct. Securities fraud actions under Section 11 of the federal Securities Act of 1933 typically seek disgorgement of that portion of the share price paid to a company that was inflated due to an alleged misrepresentation or omission in the Registration Statement (See 15 U.S.C. � 77k(a)). Damages available under Section 11 represent the difference between the amount paid for the security and the true value of that security. This measure of damages is intended to deprive defendants of any benefit obtained by their wrongdoing. As a result, damages recovered by plaintiffs in a Section 11 claim are, by their nature, restitutionary. Where damages may be characterized as restitutionary, coverage may be in doubt. In Level 3 Communications v. Federal Insurance Co., 272 F.3d 908 (2001), a case of first impression, the Seventh Circuit focused generally on the restitutionary character of a federal securities settlement and limited the coverage available under a D&O liability insurance policy. Although not addressing a Section 11 claim, the court held that the settlement of a securities fraud suit alleging that shareholders were induced to tender shares through allegedly fraudulent misrepresentations was not a loss within the meaning of the D&O insurance policy. The Seventh Circuit’s analysis did not turn on whether or not fraudulent conduct had actually occurred. Instead, the court reasoned, insurance companies should never be obligated to return to a company money or property wrongfully obtained. The court observed that the plaintiffs were not demanding return of the shares they had tendered, but instead were seeking to recover the difference in value between what they had tendered and what they received from the offer as a result of the alleged misrepresentation. Judge Richard Posner explained that “[a]n insured incurs no loss within the meaning of the insurance contract by being compelled to return property that it had stolen, even if a more polite word than �stolen’ is used to characterize the claim for the property’s return.” Courts are increasingly willing to require corporations to show that fraud claims against them are groundless and that the settlement of such claims is merely a means of avoiding the nuisance and expense of defending a lawsuit. For example, an Indiana court was indifferent to the fact that money damages paid to a plaintiff in a Section 11 case were the product of settlement as opposed to a final adjudication. The court, in Conseco Inc. v. Nat’l Union Fire Ins. Co. of Pittsburgh, 2002 WL 31961447 (Ind. Cir. 2002), noted that the insured has no greater right to something it wrongfully obtained by mistake or accident than it does to something acquired by fraud. “The critical factor is that the money or property does not belong to the insured, and it has to be returned,” the court held in Conseco. Because litigation addressing the scope and definition of insurance coverage is a matter of state law, neither the Level 3 nor the Conseco cases are controlling in either California or Delaware, two hotbeds of corporate governance and securities litigation. Nonetheless, corporate insureds across the country are experiencing the fallout in the form of preemptive action by insurers. Certain insurance companies are sending to their insureds reservation of rights letters citing recent case law as authority for the proposition that Section 11 damages are not within the definition of loss because they constitute restitution. The Ninth Circuit has not yet considered the definition of a loss in a Section 11 case involving D&O insurance. However, recent decisions by the Ninth Circuit in insurance cases outside the securities arena suggest that the circuit may follow the precedent established by the Level 3 and Conseco opinions. In Republic Western Ins. Co. v. Spierer, Woodward, Willens, Denis and Furstman, 68 F.3d 347 (1995), the Ninth Circuit found that a retainer fee accepted by a law firm but then returned after a conflict of interest was discovered was not a covered loss under the firm’s malpractice liability insurance policy. The court premised its decision on the notion that a loss within the meaning of an insurance contract does not include the restoration of an ill-gotten gain. Similarly, the Ninth Circuit has stated that a corporate dividend paid in the ordinary course of business, although part of a Memorandum of Understanding reached during settlement negotiations of several class action lawsuits arising from the terms of a merger transaction, was not a loss under an insurance policy. Safeway Stores Inc. v. Nat’l Union Fire Ins. Co. of Pittsburgh, 64 F.3d 1282 (1995). In short, even when there has been no judgment or admission of liability for fraudulent corporate conduct, companies should not expect insurers to provide coverage for payments that can be considered restitutionary, such as claims arising under Section 11 of the federal securities laws. Nor, if recent decisions are any indication, can companies count on the courts to reverse this trend. To avoid characterization of a loss as an uncovered ill-gotten gain, corporate counsel should take particular care in drafting settlement agreements. As a recent New York case demonstrates, characterizations in settlement agreements can be the basis for a denial of coverage. In Vigilant Insurance Co. v. Credit Suisse First Boston, No. 600854/02 (N.Y. Supr. Ct. July 8, 2003), a case involving a settlement with the SEC of �17(a) allegations, the court held that the corporate defendant should not receive coverage for the payment of damages defined in the consent judgment as disgorgement. The court noted that its decision might have been different had the corporation not agreed to consent language specifically identifying the payment as disgorgement of “monies obtained improperly.” Although interpreting New York law, this recent decision underlines the importance of drafting settlement agreements so as not to jeopardize available insurance coverage. Traditional agreements that neither admit nor deny liability may not go far enough to differentiate a settlement payment from an uninsurable loss. The shrinking definition of a covered loss is a troubling trend that must be considered in assessing the likelihood of coverage for Section 11 claims. Mary T. Huser is the managing partner of Bingham McCutchen’s Silicon Valley office, where she specializes in intellectual property and securities litigation. Geoff S. Beckham is a Silicon Valley-based associate in the firm’s litigation group.

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