In today’s legal environment, corporations are devoting unprecedented resources to conducting internal investigations and responding to SEC or other regulatory investigations. Frequently, those investigations can impact the likelihood, defensibility and severity of litigation against the corporation’s directors and officers. As a result, many corporations submit the costs of those investigations to their insurers for coverage under the D&O insurance program. However, often times the D&O insurer denies coverage for most if not all of those investigation costs, to the surprise of the corporation.
To better align coverage expectations with coverage reality, corporations should seek to fully understand what investigation costs coverage is and is not included within their D&O insurance program at the time the program is structured and purchased. That type of coverage analysis varies depending not only upon the specific policy language, but also the type of investigation. For example, corporations and their D&Os can be involved in the following types of investigations:
· Regulator Investigation. The SEC and other regulators can conduct either informal or formal investigations of potential wrongdoing prior to the regulator commencing a formal proceeding. These investigations frequently are ill-defined by the regulator, both with respect to the nature of the potential wrongdoing and the targets of the investigation. Sometimes, though, these investigations specifically target identifiable individuals for alleged wrongdoing.
· Internal Investigation. Corporations can conduct their own internal investigation of potential wrongdoing. For example, in response to the widespread stock option backdating allegations, many public companies conducted an internal investigation to determine if any wrongdoing occurred with respect to past stock option practices.
· Derivative Demand Investigation. Shareholders who wish to file a shareholder derivative lawsuit on behalf of the Company against D&Os for alleged wrongdoing are generally required by law to first demand that the Board of Directors authorize the Company to directly file the lawsuit. In response to that demand, the Board usually appoints a Special Litigation Committee (“SLC”) composed of disinterested outside directors, who then conduct an independent investigation of the alleged wrongdoing for the purpose of determining if the prosecution of the proposed lawsuit is in the best interests of the Company.
The following discussion summarizes many of the relevant D&O Policy terms affecting coverage for costs incurred in connection with each of those types of investigations.
A. Basic Terms of Coverage
Subject to various terms and conditions, D&O Policies generally cover “Loss” (including “Defense Costs”) incurred by Insured Persons on account of certain “Claims” against the Insured Person for a “Wrongful Act.” If entity securities coverage (i.e., Side C coverage) is purchased, the D&O Policy also covers “Loss” incurred by the Company on account of certain “Securities Claims” against the Company.
Some of the confusion about investigation costs coverage may arise because the definition of “Defense Costs” in some D&O Policies includes fees and expenses incurred in the “investigation, defense and/or appeal” of a Claim, although many other D&O Policies include within that definition only fees and expenses incurred in “defending” a Claim. Also, confusion may arise because some D&O Policies include within the definition of “Claim” not only regulatory or administrative proceedings, but also regulatory or administrative investigations.
However, these references to “investigations” in the Policy cannot be read in isolation and must be viewed in the context of the D&O Policy’s other terms and conditions. As discussed below, several of the other terms and conditions in the D&O Policy significantly limit any coverage under the Policy for many types of investigation costs.
B. Relevant Coverage Terms
In most instances, the existence of coverage under a D&O Policy for investigation costs will depend upon whether the following Policy provisions are satisfied.
1. Definition of Claim
Most D&O Policies define a “Claim” to include not only a civil or criminal proceeding, but also a regulatory or administrative proceeding. Although some D&O Policies also include within the definition of Claim regulatory or administrative investigations, most Policies do not. For purposes of entity securities coverage under Side C, D&O Policies typically exclude from the definition of Claim regulatory or administrative proceedings or investigations against the Company.
Assuming investigations are not expressly included, the definition of Claim will include administrative and regulatory investigations only if those investigations constitute a “proceeding” (some Policies refer to “formal proceeding”). At least in the context of an SEC investigation, informal investigations are generally not considered a “proceeding” or “formal proceeding” under applicable SEC rules, but a “formal investigation” authorized by the Commission itself (as opposed to staff at the SEC) usually is considered a “proceeding” or “formal proceeding.”
Although administrative or regulatory proceedings or investigations against the Company are typically not included within the definition of “Claim” even if the Policy includes entity securities coverage, some Policies by endorsement include a regulatory or administrative proceeding against the Company while that proceeding is also pending against Insured Persons. However, that extension of coverage, like coverage for the Insured Persons, is subject to the other Policy terms and conditions summarized below, which could further limit entity coverage for such a proceeding.
2. Claim Against Insured for Wrongful Act
Pursuant to the Insuring Agreements in the D&O Policy, coverage only exists for certain Claims made against Insureds for Wrongful Acts. This provision can limit coverage for investigation costs in several contexts. First, the investigation must target a specific Insured for alleged wrongdoing. For example, an SEC investigation frequently does not identify a target of the investigation or specific alleged wrongdoing, and therefore would not constitute a Claim against an Insured Person for a Wrongful Act. Even if the SEC issues a subpoena to a director and officer, that subpoena may simply seek to obtain information and documents from the director and officer as a witness and does not necessarily mean that the SEC is targeting that individual or is alleging that the individual committed any wrongdoing. D&O Policies are specifically designed not to provide coverage for D&Os who are merely witnesses, and against whom no Claim is made. However, if the SEC investigation specifically targets an individual for alleged wrongdoing, the investigation costs incurred by that individual should be considered to be incurred as a result of an investigation against the individual for a Wrongful Act.
Second, in the context of internal investigations, frequently the Company is not investigating specific individuals for identified wrongdoing. Instead, the Company seeks to determine if someone committed wrongdoing that needs to be addressed. Costs incurred by the Company in conducting such an internal investigation are not costs incurred by an Insured on account of a Claim against such Insured. Rather, those corporate costs are business expenses incurred by the Company consistent with the Company’s obligation to identify and correct internal wrongdoing. In other words, those Company investigation costs are incurred not to defend or resist allegations of wrongdoing, but to determine if allegations of wrongdoing should be asserted. Costs incurred by a director or officer in responding to such an internal investigation by the Company would likely be excluded from coverage even if the investigation constituted a “Claim against the Insured Person for a Wrongful Act” since such investigation would presumably be by or on behalf of the Company and thus subject to the insured v. insured exclusion.
Third, in the context of a derivative demand investigation, costs incurred by the Company to conduct that investigation are not incurred for the purpose of defending or responding to a Claim against Insureds for a Wrongful Act. Instead, the Company’s costs are incurred to determine if the Company should prosecute a Claim against the directors and officers. Although the results of that internal investigation may be helpful to directors and officers in defending a derivative lawsuit against them, the use of the investigation results by directors and officers does not change the purpose and nature of the investigation. In fact, if coverage under the D&O Policy existed for the Company’s investigation costs, such coverage arguably taints the independence of the investigation since it suggests that the purpose of the investigation is to defend directors and officers rather than objectively investigate whether any wrongdoing occurred.
Some D&O Policies expressly include coverage for the Company’s investigation costs in response to a shareholder derivative demand. That coverage is typically subject to a modest sublimit and is granted through an additional insuring agreement (thus confirming that the coverage does not otherwise exist under the standard insuring agreements). The purpose of that limited coverage is intended to encourage Companies to devote sufficient resources to the investigation. However, costs incurred by directors and officers in responding to the derivative demand investigation by the Company may be considered a covered Loss depending upon the circumstances, including whether the individual is a target of the investigation or a defendant in other related litigation which is pending at the time of the derivative demand investigation.
3. Loss Incurred by Insureds
Pursuant to the Insuring Agreements and the definition of Loss in the D&O Policy, coverage is afforded only for certain costs or other loss for which the Insured is “legally obligated to pay.” Frequently, counsel and other experts retained to respond to a regulatory investigation or to conduct an internal investigation are retained by the Company and represent only the Company. In that case, directors and officers would have no obligation to pay the fees and expenses incurred by the counsel or expert, and thus those fees and expenses would not be covered Loss under the Policy. A Company’s obligation to indemnify its directors and officers does not change that coverage result since indemnification law, like the D&O Policy, first requires the director or officer to be legally obligated to pay the amount which is purportedly being indemnified. Again, though, if a director or officer personally retains legal counsel or hires experts to respond to an investigation which specifically targets that individual for wrongdoing, coverage may exist for such costs depending upon the circumstances (including whether a Claim has been made against the individual for alleged wrongdoing).
Although some Companies may be surprised and disappointed to learn that costs incurred by the Company in responding to a regulator investigation or in conducting an internal investigation are not covered under the D&O Policy even though the results of that investigation may implicate exposure to directors and officers, the lack of coverage under the D&O Policy for such costs is consistent with the underlying purpose and premise of D&O insurance. Those investigation costs by the Company are, in many instances, business expenses incurred by the Company which should not erode coverage afforded under the D&O Policy for claims against directors and officers.
However, it is reasonable for directors and officers to request coverage for costs incurred by them to respond to investigations which target the director and officer for alleged wrongdoing. But, that request should be made, and confirmation of that coverage should occur, at the time the Policy is purchased, not when the costs are incurred.