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When allegations of fraud against directors and officers are rampant, a principal benefit of insurance coverage is the assurance that an insurer will indemnify directors and officers if their corporation cannot or will not. Yet sometimes insurers refuse to provide this indemnification by blaming the directors and officers — a response that often should provoke skepticism. Increasingly, insurers are balking at providing coverage for directors and officers (D&O policies) in certain circumstances that insurers label “restitution” or “disgorgement.” This typically occurs when the insurer believes that the directors or officers are being sued to require the return of money that they should not have had in the first place. Insurers argue, for example, that one cannot steal money from another person and then be covered by insurance for returning the money to its rightful owner. But insurers can overreach with this concept, effectively pulling the rug out from under their policyholders faced with typical securities claims. D&O policies usually provide coverage for “loss” from claims against insureds for alleged wrongful acts. Loss is often defined to include settlements and judgments. But sometimes excluded from the definition of loss is reimbursement, disgorgement, or, somewhat vaguely, “matters uninsurable.” Many cases brought against directors and officers settle without an admission of wrongdoing or any allocation of damages among various forms of relief sought. Although loss includes settlements, insurers sometimes deny coverage on the basis that the settlements actually represent disgorgement or the return of money wrongfully obtained. In light of the broad scope of typical D&O coverage, policyholders should view “insurability” or disgorgement arguments raised by insurers with a healthy dose of skepticism. Indeed, among the most heavily debated and litigated provisions in D&O policies these days is what constitutes a covered loss. Based on recent cases, the trend is clear: An insurer simply calling or labeling a settlement restitutionary does not make it so, and that label does not mean that the settlement money is not covered under the policy. Courts have looked beyond labels to determine whether settlements constitute compensation for alleged harm (generally covered) or whether they involve the return of funds allegedly improperly received (not covered, insurers will argue). WELCOME TO LEVEL 3 The case at the center of this tug of war is the decision by the U.S. Court of Appeals for the 7th Circuit in Level 3 Communications Inc. v. Federal Insurance Co. (2001). Level 3 involved a “bump-up” claim — a claim by former shareholders that stock they sold to the company was undervalued because of the company’s fraudulent misrepresentations. The plaintiffs sought to rescind the transaction and recover their shares (or rather the monetary value of the shares because the company could not be reconstituted). Level 3 settled the lawsuit for $12 million and sought coverage for the settlement under its D&O policy. The insurer, denying coverage, argued the settlement represented disgorgement of ill-gotten gains and was thus uninsurable as a matter of law. The 7th Circuit agreed, holding 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.” Central to the holding in Level 3 is the court’s observation (right or wrong) that the damages were “restitutionary in character” because the plaintiff sought to “divest the defendant of the present value of the property obtained by fraud. . . . In other words, [the relief] seeks to deprive the defendant of the net benefit of the unlawful act.” STRETCHED TOO FAR Insurers have invoked Level 3 in a great majority of securities claims submitted under D&O policies. In recent cases, however, courts have shown a tendency to take a more careful look at the true nature of the settlement, rejecting insurer attempts to stretch Level 3 too far. In the New York case of Vigilant Insurance Co. v. Bear Stearns Co. (2006), for example, the court found that there was an issue of fact about “whether the portion of a settlement attributed to disgorgement actually represented ill-gotten gains or improperly acquired funds.” The issue here was whether a policyholder could recover from its insurers money that it had paid in settlement with the Securities and Exchange Commission, which had alleged misconduct on behalf of certain research analysts. Bear Stearns had agreed to an $80 million settlement, $25 million of which was expressly designated as “disgorgement of commissions and other monies.” But Bear Stearns submitted evidence the settlement amount was based on market share instead of the amount of commissions or fees it received, which, the court found, was enough to preclude summary judgment in favor of the insurer. The result was similar in the 9th Circuit case of Unified Western Grocers Inc. v. Twin City Fire Insurance Co. (2006). There, the 9th Circuit overturned a district court decision denying coverage on the basis that the underlying complaint sought only restitution of ill-gotten gain. The court held that the “label of �restitution’ or �damages’ does not dictate whether a loss is insurable.” The fundamental question, said the court, was “not whether the insured received �some benefit’ from a wrongful act, but whether the claim seeks to recover only the money or property that the insured wrongfully acquired.” Interestingly, in this case $13.5 million was sought in the underlying complaint while only $8.5 million was alleged to have been wrongfully received by the insureds. Notwithstanding how the relief sought was characterized by the insurer and lower court, clearly the plaintiffs were after damages beyond the return of alleged ill-gotten gains. Citing to an allocation provision in the D&O policy, the court noted that “[w]hen an underlying complaint contains a mixture of covered and uncovered loss, the insurer is obligated to allocate the reimbursement of funds between the two types.” PUBLIC POLICY Insurers also sometimes argue, using language in some policies that loss does not include “matters uninsurable under the law applicable to this coverage,” that public policy precludes coverage for relief that appears to be restitutionary in nature. Policyholders, just like the court in Federal Insurance Co. v. Continental Casualty Co. (W.D. Pa. Nov. 22, 2006), should be wary of this argument, too. At issue in Federal were claims for pre-bankruptcy petition transfers to insured officers and directors and fraudulent conveyances. The insurer argued that the claims were for restitution and thus constituted “matters uninsurable.” The insureds, for their part, countered that restitution is uninsurable as a matter of law “only if the insured’s culpability is either proven or admitted.” Reluctant to allow the insurers to use public policy as a basis for denying coverage, the court held that if the insurer “wishes to prevail on a generic �public policy’ ground, as opposed to the more specific ground available under [a specific exclusion in the policy], it must demonstrate a coherent legal basis for concluding that the law . . . precludes coverage.” One California state court has observed that the “line between damages and restitution is often fine or invisible.” Accordingly, it is quite important for directors and officers to fully understand what relief may be viewed as covered within a D&O policy’s definition of loss. The insurer’s assessment is hardly determinative. Most companies purchase D&O insurance because of concerns over securities claims. Insurers, of course, do not underscore their insurability arguments on the selling end, lest the policy sound hollow. But on the claims end, the insurability argument has become more common. There may be cases that fit a narrow fact pattern where a policyholder has been adjudicated to have wrongfully taken funds that now must be returned. But most securities claims cannot be fairly described as such. Courts seemingly are receptive to evidence that settlements — no matter how labeled — are not strictly restitutionary in nature. Indeed, particularly where multiple forms of relief are sought by the plaintiffs and a case is settled without any admission of wrongdoing, directors and officers should beware of attempts by an insurer to characterize any settlement as one requiring disgorgement. Coverage may still be available.
Matthew J. Schlesinger and Gary Thompson are partners in the Washington, D.C., office of Reed Smith, and Robert H. Owen is an associate in the Pittsburgh office. Their firm’s insurance recovery practice represents policyholders in D&O liability and other types of coverage disputes with insurers.

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