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In the legal morass of the Enron meltdown, several insurance coverage disputes have bubbled to the surface. And while the stakes in the Enron cases may be huge and the facts sensational, insurance lawyers say the disputes highlight a trend that reaches beyond the bankrupt poster child for corporate wrongdoing. The cases — one batch involving directors and officers, or D&O, insurance, and the other surety bonds — demonstrate a recent wave of aggressive defense strategies by insurers seeking to avoid paying claims on the grounds of fraud, or at least a failure to disclose material information. Such defenses have long been common in certain areas, such as life insurance and homeowners’ insurance. What’s on the rise, though, is the use of these defenses against more sophisticated corporate policyholders in the D&O and surety bond arenas. In the D&O cases, several of the insurance companies that covered Enron have told the U.S. Bankruptcy Court in Manhattan that Enron’s applications for coverage contained material misrepresentations. The cases filed by two of Enron’s insurers — Royal Insurance Co. of America and St. Paul Mercury Insurance Co. — are still in early stages. A third company, primary D&O insurer Associated Electric & Gas Insurance Services Ltd., has said it will not make payments until ordered to do so by the bankruptcy court. The court on procedural grounds has refused a request by Enron to order distribution of $30 million for directors’ and officers’ legal fees. How far the Enron cases will go is unclear. But for the insurance industry, the litigation may represent a potent wedge in the drive to expand the material misrepresentation defense. “You’re seeing more and more cases in which insurers are alleging material misrepresentation in the application, either to rescind the entire policy or to deny coverage in a particular case,” says business litigation partner Karl Belgum of Thelen Reid & Priest in San Francisco, who represents D&O policyholders in securities litigation. “It’s a very aggressive defense — you’re basically suing your customer.” Belgum is at a loss to explain exactly why such cases have mushroomed in the past few years. But he says the trend fits into the generally more litigious relationship between insurers and their clients that has prevailed since the scorched-earth battles over asbestos and Superfund coverage that began in the 1980s. Belgum’s New York-based partner Richard Swanson says it’s insurers’ “willingness to push” fraud-based defenses that is new. And Swanson, who reviews several dozen D&O policy applications a year, says the high profile of the Enron fracas is likely to embolden insurers further. The issue has already come up with his clients, he says. “It’s making insurance companies think twice about whether or not they have an allegation of fraud that can eliminate their policy obligations.” Others agree. A Los Angeles lawyer who asked not to be named says that in the past, the material misrepresentation allegation has usually been a “knee-jerk reaction” on the part of insurance carriers. Insurers “may raise it as a position,” this lawyer says, but “generally do not tend to litigate it.” In the Enron case, the lawyer continues, “I think they’ll litigate it, and if they litigate it and get some good appellate decision, the carriers may get some precedent.” The issue may be especially relevant in California, where the supreme court in February refused to review a pro-insurer appellate decision on D&O coverage. In that decision, California Amplifier v. RLI Insurance Co., 94 Cal.App.4th 102, an appeals panel held that coverage was precluded — even for the purposes of settlement — because the underlying claim pertained to intentional wrongful conduct, not just negligence or recklessness. The ruling applies to only a small universe of state securities class actions, says securities litigation partner Karen Kennard of McCutchen, Doyle, Brown & Enersen in San Francisco. But its impact has been significant, Kennard says, with insurers in related cases citing the decision to deny coverage and walk away from settlement talks. And its general holding — that there is a public policy interest in not allowing willful misconduct to be indemnified by the insurance industry — could be relevant in the Enron litigation and could be picked up by other courts, she says. A lawyer for RLI, Michael Prough of the Walnut Creek, Calif., insurance litigation boutique Morison-Knox Holden Melendez & Prough, declined to comment. Other practitioners point out that Enron’s D&O carriers — and any copycats waiting in the wings — won’t have an easy time. There’s little case law on material misrepresentation in the D&O underwriting process, says Edward Joyce, who heads the insurance coverage practice group at Heller Ehrman White & McAuliffe’s New York office. In one published case, the court applied a tough standard of proof, he says, ruling that conclusory allegations are insufficient and hard facts must be presented showing the insurer would not have written the policy if it had known what the policyholder knew. “Even if they do go to argue it on the merits, that’s a tough mountain for them to climb,” Joyce says. Moreover, Joyce and others say, an otherwise strong fraud defense may be weakened by economic factors in the notoriously volatile insurance market. They say the late ’90s, when Enron was rising to the top of the Fortune 500, were a soft market for insurance. That means insurers were competing actively for business and may not have scrutinized annual policy renewal applications carefully. To succeed, Enron’s insurers will have to show not only that Enron supplied false or incomplete information on its application, says Thelen’s Swanson, but also that the misrepresentation was material and that the insurers relied on it. If in their haste to write policies, the insurers routed Enron’s applications “straight from the secretary’s desk to a drawer at the broker,” they will have trouble proving they relied on any misrepresentations, he says. Like the D&O cases, the litigation alleging fraud in Enron-related surety bonds is a type that has been on the rise for the past few years, lawyers in the area say. The cases involve bonds purportedly backing gas futures trades by businesses linked to Enron. The sureties allege the net effect of a series of transactions was something entirely different — essentially, a guarantee of repayment on loans from JP Morgan Chase to Enron. The bank, for its part, maintains the sureties were obliged to pay on demand, as in a letter of credit, without even a right to investigate the claim. A federal district judge found that there was enough evidence the sureties were deceived as to the fundamental nature of the transactions to deny the bank’s request for summary judgment and set a December trial date. Such fraud cases have multiplied in recent years as the surety industry has expanded beyond covering the performance of construction and other projects to backing commercial transactions, says Marilyn Klinger, who heads the surety practice group at Sedgwick, Detert, Moran & Arnold. Klinger estimates such disputes have generated about 10 published opinions around the country, and says most have exonerated the surety. “These fraud-in-the-inducement cases are becoming more prevalent because there was a significant increase in the surety industry writing commercial sureties, which seemingly allows for more of this kind of thing to occur than in the vast majority of surety bonds written around the country,” she says. The more exotic bonds written in recent years have elements of both traditional surety bonds and financial guarantee bonds that typically back corporate or muni bonds, Klinger says. Financial guarantee bonds are more strictly regulated by many states, including New York, where the Enron case was filed, and California, and the law is still “very muddy” as to which bonds come under those stricter laws, she says. But, as in the D&O cases, the soft insurance market at the time the bonds were issued may work against insurers’ aggressive tactics. Enron and J.P. Morgan Chase’s “logical card to play,” says Thelen’s Belgum, is that the sureties “knew exactly what they were selling and were just happy to get the premium in the door.”

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