Language Matters

I spend the majority of my day reading, interpreting and discussing directors and officers’ (D&O) liability insurance policies. In so doing, I am constantly struck by the fact that insured parties and insurers alike presume the language of an insurance policy is secondary to general practices, fervently held beliefs and individual understandings. Recently, the Eighth Circuit Court of Appeals reminded an insured – and its broker – that the language of the policy trumps such practices, beliefs and understandings.

The context for this harsh reminder is a private company D&O insurance policy that barred coverage for claims alleging violations of certain securities laws, including the Securities Act of 1933, Securities Exchange Act of 1934 and state Blue Sky or securities law. While the insured and broker both believed the exclusion was limited to the insured’s own securities (and introduced testimony supporting such a belief), the exclusion did not contain any such limitation.

Applying the plain language of the exclusion, in Leonard v Executive Risk Indemnity (in re SRC Holding), the Eighth Circuit held that the policy’s securities exclusion barred coverage for claims arising out of the insured’s underwriting and sale of bonds. And while the policy in Leonard was issued to a private company, the central point – language matters – is equally applicable to all public companies.

Denying coverage
In Leonard, the insured, Miller & Schroeder (M&S), was a securities underwriter and broker. Between 1996 and 1999, M&S underwrote $1.4 million worth of bonds, which it sold in 12 municipal offerings. All of the bonds defaulted. As a result, purchasers of the bonds filed lawsuits and arbitration proceedings against M&S and its brokers, directors and officers.

The plaintiffs alleged violations of federal and state securities laws, the common law and the rules and regulations of the National Association of Securities Dealers. M&S and its directors and officers sought coverage under their private company D&O insurance policy for the various lawsuits and proceedings. Relying on the securities exclusion, provider Executive Risk Indemnity (ERII) denied them any coverage.

M&S defended against the litigation incurring $750,000 in legal fees. It was also assessed millions of dollars in damages and, as a result, it filed for bankruptcy protection. The trustee of the bankruptcy estate initiated an adversary proceeding against ERII alleging breach of contract and seeking a declaration that the D&O policy afforded coverage for the defense expenses and resulting judgments. Former M&S directors and officers intervened, seeking the same relief.

At issue was the policy’s securities exclusion, which barred coverage for, among other things, any claim arising out of: (a) ‘the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, any other federal law, rule or regulation with respect to the regulation of securities, any rules or regulations of the SEC, or any amendment of such laws, rules or regulations’, and (b) ‘any provision in the common law imposing liability in connection with the offer, sale or purchase of securities’.  The dispute centered on whether the exclusion applied to alleged securities violations that involved securities other than those of M&S.

Reversal of fortune
Limiting the applicability of the securities exclusion, the bankruptcy court and the district court held that the exclusion barred only coverage for claims arising from the sale of M&S’ own stock. Both rulings were based, in part, on the deposition testimony of M&S’ insurance broker, who testified that the securities exclusion, a standard exclusion in private company D&O policies, is intended to bar coverage for liability arising from the insured’s sale of its own stock.

According to the Eighth Circuit explanation that rejected the bankruptcy court and the district court decisions: ‘Because the typical effect of [the securities exclusion] is to preclude coverage resulting from the insured’s sale of its own securities – so the courts’ reasoning goes – the meaning of [the securities exclusion] in this policy must accord with that typical effect.’ As the lawsuit did not arise from M&S’ sale of its own stock, the lower courts found that the exclusion was inapplicable to bar coverage for the lawsuit.

The Eighth Circuit reversed the decision. It found that the exclusion, as written, was unambiguous. It further stated that the effect of the securities exclusion ‘as it may be generally applied in practice, is not the legal authority that governs our coverage inquiry here; it is the mutually agreed-upon policy’s plan language that binds M&S and ERII in the first instance.’ As such, the court held that the lower courts’ reliance upon extrinsic evidence to evaluate the purpose or intent of the exclusion was erroneous. 

In an effort to create an ambiguity, the insureds argued that other policy provisions created an irreconcilable conflict with the plain meaning of the securities exclusion. Specifically, they asserted that, because the policy contained an endorsement excepting the applicability of the securities exclusion in the context of a certain transaction, the exclusion was ambiguous. The court disagreed, finding that the endorsement merely provided an exception to the broader exclusion. 

The insureds further argued that ERII’s interpretation of the policy’s securities exclusion rendered the errors and omissions (E&O) exclusion superfluous, creating an ambiguity. The E&O exclusion barred coverage for certain professional services of the insureds including investment banking services, security broker/dealer services and securities underwriting. As is standard, the exclusion contained a carve-out for claims based on a director’s or officer’s failure to manage or supervise any company’s division or group offering such services.

Acknowledging that this exclusion poses a more difficult question, the Eighth Circuit found that the E&O exclusion bars coverage for claims that would not be excluded under the securities endorsement and, therefore, the exclusion is not superfluous. The court also noted that ‘any overlapping in the coverage excluded’, by itself, is ‘not sufficient to disregard the broad and unqualified language’ of the exclusion.

Unreasonable expectations
The Eighth Circuit also rejected the insureds’ arguments that applying the plain meaning of the securities exclusion not only renders the policy’s coverage illusory but is also contrary to the insured’s reasonable expectations. Given that the D&O policy affords coverage for claims other than securities-related claims and that the insureds did not assert that a certain portion of the premium was allocated for such coverage, the court found the illusory-coverage doctrine did not apply. As for the insured’s reasonable expectations, the court explained that, because the securities exclusion is unambiguous, the doctrine was simply inapplicable.

The Leonard decision is an important reminder for insureds and insurers that, while course-of-dealing, individual understandings and historical practices may be relevant, it is the policy language that most often controls. As the Eighth Circuit explained: ‘The language [the parties] have mutually negotiated and agreed to is the best evidence of what those parties intended.’ While some courts will undoubtedly examine the historical application and purported intent of the policy provision (see Alfin v Pacific Insurance), Leonard underscores the importance for insureds and insurers to retain skilled counsel to carefully examine the proposed policy language before a claim is made, during the negotiation process, and in the event the language does not conform to the intent of either the insured or insurer, the policy should be modified. Once a claim has been made, courts will turn to the language of the policy to determine (rightly or wrongly) the parties’ intent.