Although securities class action suits brought under the Securities Act of 1933 (the 1933 Act) and the Securities Exchange Act of 1934 (the 1934 Act) against directors and officers have been trending down in frequency over the past several years, claim severity has been up and dramatically rising. With these trends and a spike in initial public offerings in 2007, there are undoubtedly more questions for risk managers, lawyers and consultants about the scope of coverage under D&O liability insurance policies.
One question receiving attention recently is whether, or to what extent, claims against directors and officers under Section 11 of the 1933 Act are insurable. Historically, they were not viewed as insurable under D&O policies because the type of damages sought - disgorgement or restitutionary damages - are not covered. However, the federal court's decision earlier this year in CNL Hotels & Resorts, Inc. v. Houston Casualty Company ("CNL"),1 while largely conforming to existing law precluding coverage for such claims, expressly left the door open for more analysis of this question. This article discusses the anatomy of a Section 11 claim, the holding in CNL and the implications on the D&O insurer market.
What Is A Section 11 Claim?
The 1933 Act mandates the filing of registration statements with the SEC for all companies that issue public securities. Under Section 11 of the 1933 Act, any purchaser of a security covered by a registration statement may sue if the registration statement contained a material misrepresentation or omission.2 Individuals who sign the registration statement, directors of or partners in the issuer, professionals who participate in the preparation of a registration statement and underwriters of the security are all potentially liable under Section 11. The damages available under Section 11 are the amount paid for a security less:
the value of the security at the time the suit was brought;
the price of the security if sold in the market before suit; or
the price at which the security is disposed of after suit, if greater than the value when suit was brought.3
Section 11 is a strict liability statute, such that the heightened pleading standards of the Private Securities Litigation Reform Act of 1995 (PSLRA) and Fed. R. Civ. P. 9(b) do not apply. Plaintiffs must only satisfy the liberal pleading requirements of Fed. R. Civ. P. 8(a), thereby making the Section 11 claim a popular one for the securities plaintiffs' bar.
The CNL Decision
In CNL, coverage for an underlying Section 11 claim settlement was in issue. In the underlying matter, the plaintiff shareholders alleged that they had purchased stock at artificially inflated prices as a result of materially false and misleading statements in CNL Hotels and Resorts, Inc. ("CNL Hotels") prospectuses. The plaintiffs sought a refund of the difference between the price they paid for CNL Hotels' stock and the actual value of the shares at the time the lawsuit was filed. After protracted litigation, CNL Hotels settled the class actions. Although CNL Hotels did not admit liability, it set up a $35 million settlement fund for the Section 11 claims. The court approved the settlement and the case was closed.
CNL Hotels sought to recover the settlement fund amount and associated expenses under a D&O policy issued by Twin City Fire Insurance Co. ("Twin City") and excess liability policies issued by Houston Casualty Co. ("HCC") and Landmark American Insurance Co. (Landmark). After the insurers denied coverage, CNL Hotels filed a coverage lawsuit. CNL Hotels settled its claims with its primary insurer, Twin City, early on in the litigation. The excess insurers moved for summary judgment on various grounds, including that the settlement payments represented a type of disgorgement, rather than an actual "loss" as defined in the policy, and that any losses resulting from violations of Section 11 are uninsurable.
The primary policy defined "loss" as sums that insureds are "legally liable to pay solely as a result of any claim insured by this policy, including claims expenses, compensatory damages, settlement amounts and legal fees and costs awarded pursuant to judgments, but excluding fines, penalties, taxes, any amount allocated to uncovered loss pursuant to Section VII of this policy, or matters uninsurable pursuant to any applicable law."4 CNL Hotels argued that its payment of the settlement constituted a covered loss because the definition of "loss" in the policy included sums that CNL Hotels was "legally obligated" to pay, including settlement amounts. The court disagreed with CNL Hotels and stated that "the mere fact that CNL Hotels has a legal obligation to pay a certain amount is insufficient, on its own, to compel reimbursement by its insurers."5
The court further agreed with Landmark's and HCC's position that not all settlement payments represent a "loss" to an insured. The court, applying New York law, stated that it is "well-settled that a party may not insure itself against the risk of having to return money that it has obtained improperly."6 The court went on to say, "This is because restitution of ill-gotten funds does not constitute 'damages' or a 'loss' as those terms are used in insurance policies."7 The court also explained that New York law "is in accord with decisions from numerous other jurisdictions," citing Level 3 Communications, Inc. v. Federal Insurance Co. ("Level 3").8 CNL Hotels attempted to distinguish Level 3 on the basis that it dealt with allegations of violation of Section 10(b), and not Section 11. The court rejected CNL Hotels' argument, reasoning that "the important factor in determining 'loss' is the restitutionary character of the payment at issue, not the malfeasance (or lack thereof) on the part of the entity making it."9 CNL Hotels' further attempt to distinguish Level 3 , because the policy in Level 3 did not define "securities claim," similarly failed. The court stated that "regardless 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. It is simply not reasonable for an insured to assume otherwise."10
Finally, CNL Hotels argued that it would be unfair to preclude individual directors and officers from recovering payments on Section 11 claims, as such individuals can be held liable even if they did not receive any money from the purchasers of the overpriced securities. Although the court noted that no directors or officers were seeking such recovery in the case, it went on to state that these reimbursement obligations might not be barred, inasmuch as "in a Section 11 case, if an entity makes a payment that constitutes something other than disgorgement of its own ill-gotten gains, it has suffered a loss" that may be insurable.11 The court expressly stated: "Section 11 claims are not per se uninsurable."12
The Impact Of CNL
The CNL decision further solidifies prior case law in the D&O context that found that settlements that were, in essence, disgorgements of ill-gotten gains, are not covered. While the CNL decision was favorable to insurers on this issue, the CNL court did leave open the possibility that some claims under Section 11 are insurable. Thus, this decision allows insurers and policyholders to revisit the issue of whether specific language in D&O policies extends to cover Section 11 claims. Some insurers have shown a willingness to clarify the scope of this coverage, and purchasers may be encouraged to analyze this specific aspect of their coverage. Additionally, since the process of obtaining court approval for settlement of a 1933 Act claim calls for characterization of the settlement, and the settlement may not necessarily be deemed to constitute a disgorgement of ill-gotten gains, comparing settlement contours against policy language would appear to be a continuing challenge in the Section 11 context despite CNL and the cases upon which it relies.1 No. 6:06-cv-324-Orl-31JGG, 2007 WL 788361 (M.D. Fla. Mar. 14, 2007).
2 15 U.S.C. 77k(a).
3 15 U.S.C. 77k(e); In re AFC Enters. Sec. Litig., 348 F. Supp. 2d 1363, 1379 (N.D. Ga. 2004).
4 CNL, 2007 WL 788361, at *4.
6 Id. ( citing Vigilant Ins. Co. v. Bear Stearns Companies, In c. , 2006 WL 118368 *4 (N.Y. Sup. 2006)).
7 Id., quoting Vigilant Ins. Co. v. Credit Suisse First Boston Corp . , 782 N.Y.S.2D 19, 20 (App. Div. 2004).
8 272 F.3d 908 (7th Cir. 2001) and Conseco, Inc. v. Nat'l Union Fire Ins. Co . , No . 2002 WL 31961447 at *10 (Ind. Cir. Ct. Dec. 31, 2002).
9 CNL, 2007 WL 788361, at *6.
11 CNL, 2007 WL 788361, at *7.
Steven D. Davis is Co-Chairman of Stradley Ronon's Insurance Practice Group and can be reached at (215) 564-8714. Heather M. Tashman is an Associate in the firm's Litigation Practice group and can be reached at (215) 564-8076.