When the Securities and Exchange Commission (“SEC”) or other government agency launches an investigation, companies can spend millions of dollars in response to the agency’s subpoenas and other requests for documents and information. Many D&O policies purport to insure the fees and costs companies incur in responding to government investigations. However, policyholders seeking insurance coverage for such fees and costs need to be aware of a recent Tenth Circuit decision, MusclePharm Corp. v. Liberty Insurance Underwriters, Inc. No. 16-1462, 2017 WL 4675701 (October 17, 2017), which calls into question the scope of coverage for investigation response costs. This ruling, which turned heavily on the policy language in MusclePharm’s D&O policy, highlights the importance of understanding the scope of investigative coverage your company is purchasing and the requirements for triggering coverage thereunder.
MusclePharm dealt with coverage for an SEC investigation of MusclePharm for alleged security law violations. Specifically, the Tenth Circuit examined whether a July 8, 2013 SEC Order Directing Private Investigation and Designating Officers to Take Testimony (the “July 8 Order”) was a “Claim” for a “Wrongful Act.” The Tenth Circuit held that this formal order of investigation was not a “Claim” as defined in the policy because it was neither a claim for “non-monetary relief” nor a “formal administrative or regulatory proceeding.” It also found that the July 8 Order did not allege a “Wrongful Act” as required by the policy.
Relying on legal dictionary definitions, the Tenth Circuit found that “relief” means “legal remedy or redress,” or the “redress or benefit,” especially “equitable in nature (such as an injunction or specific performance), that a party asks of a court.” Id., *5. The court found that the “SEC sought to determine, through documents and testimony, whether there would ultimately be any basis for seeking monetary and/or non-monetary relief from MusclePharm. By this action, the SEC was not seeking relief, but only gathering information.” Id. Thus, there was no demand for non-monetary relief. The Tenth Circuit also found that the July 8 Order was not a “proceeding” because the SEC’s conduct was not part of “the regular and orderly progression of a lawsuit.” Id., *6. Finally, the court found that the July 8 Order was not a “formal investigation” because the policy limited coverage to investigations that took place only after a Wells Notice had been issued. Id.
The Tenth Circuit’s narrow reading of the policy language contrasts with decisions from other jurisdictions holding that the SEC’s demand for documents or testimony is a covered demand for non-monetary relief. For example, in Minuteman Int’l Inc. v. Great Am. Ins. Co., , the Northern District of Illinois found that “[a] demand for ‘relief’ is a broad enough term to include a demand for something due, including a demand to produce documents or appear to testify” and an SEC subpoena was “a substantial demand for compliance by a federal agency with the ability to enforce the demand. No. 03 C 6067, 2004 WL 603482, *7 (N.D. Ill. Mar. 22, 2004)Likewise, a recent decision from the Southern District of New York, Patriarch Partners, LLC v. AXIS Ins. Co., , found that a subpoena “sought ‘nonmonetary relief’ in the form of the documents that were to be produced.” No. 16-CV-2277 (VEC), 2017 WL 4233078, *5-7 (S.D.N.Y. Sept. 22, 2017) But see Employers’ Fire Insurance Co. v. ProMedica Health Systems, Inc., 524 Fed. Appx. 241, No. 12-3104, 2013 WL 1798978, *247-251 (6th Cir. April 30, 2013) (SEC CID was not a Claim because it did not allege a Wrongful Act or seek relief).
A troubling aspect of the MusclePharm decision is the Tenth Circuit’s treatment of what is necessary to have an “allegation” of a “Wrongful Act.” The Tenth Circuit again looked in a legal dictionary and found that “alleged” means “[a]sserted to be true as described,” or “[a]ccused but not yet tried.” Focusing on boilerplate language in the July 8 Order stating that it should not be construed as an indication that a violation had actually occurred, the Tenth Circuit found that there were no allegations of wrongdoing: “The SEC was not asserting that MusclePharm had broken any laws; rather, the SEC was investigating to determine whether it had.” 2017 WL 4675701, *6-7. In making this analysis, the court ignored that “the July 8 Order stated that the “SEC ‘has information that tends to show that from at least January 1, 2011,’ MusclePharm ‘possibl[y]’ violated provisions of the Securities Act of 1933 and the Exchange Act of 1934.” Id. at *2. A reasonable policyholder would understand that asserting a “possible” violation of securities law is the equivalent of being “accused but not yet tried.” In addition, the 10th Circuit’s constricted interpretation of a “Wrongful Act” may have implications outside of a D&O claim, such as to an Errors & Omission’s policy that also typically responds to “Claims” for a “Wrongful Act.”
The MusclePharm decision conflicts with a number of decisions from other jurisdictions that have found that government investigations by their nature allege “Wrongful Acts.” See, e.g., Polychron v. Crum & Forster Ins. Co., 916 F. 3d 461 (8th Cir. 1990); Ace Am. Ins. Co. v. Ascend One Corp., 570 F. Supp. 2d 789 (D. Md. 2008); Agilis Benefit Servs. LLC v. Travelers Cas. & Sur. Co. of Am., No. 5:08-CV-213, 2010 WL 8573372, at *7 (E.D. Tex. Apr. 30, 2010); Syracuse Univ. v. Nat’l Union Fire Ins. Co., No. 2012EF63, 2013 WL 3357812, at *4-5 (N.Y. Sup. Mar. 7, 2013).; National Stock Exchange v. Federal Insurance Company, No. 06 C 1603, 2007 WL 1030293, at *5 (N.D.Ill. Mar. 30, 2007). Focusing on the serious and specific nature of the investigations, these courts found that allegations of “Wrongful Acts” could be implied from the investigation even without direct allegations of wrongdoing. These decisions are beneficial to Policyholders because government investigations are often undertaken where the government agency believes that wrongdoing has occurred even if not directly stated in the investigation documents. Accordingly, as a policyholder, it is important to recognize how choice of law may impact your case.
The Tenth Circuit’s decision highlights the importance to policyholders of ensuring that D&O policies contain the appropriate language to properly cover investigations that government agencies may undertake. The questions of whether to insure such investigations, and the scope of coverage a company needs to have, can be complicated and are subject to many variables, including the size of the company, whether it is publically or privately held, and whether it is operating in a government regulated industry. Moreover, the coverage may be subject to sublimits, and it may be difficult to know whether the sublimits an insurer offers are sufficient to fully insure an investigation; as the MusclePharm case shows, policyholders can incur millions of dollars responding to investigations. Companies also should be aware that a policy’s overall limits may be reduced by amounts spent to respond to government investigations, potentially leaving less insurance available for the company and individual directors and officers in the event that the government initiates a formal lawsuit. Finally, insurers can charge substantial premiums for government investigation coverage, significantly increasing the cost of D&O policies. Reed Smith’s Insurance Recovery Group (IRG) has substantial experience advocating and litigating D&O claims on behalf of policyholders, and also counseling companies engaged in negotiating the placement or renewal of D&O coverage. Consequently, the IRG is well placed to assist policyholders that may have questions regarding whether and to what extent their D&O policies insure government investigations, as well as other coverage issues. Interested clients are urged to contact the undersigned or another member of the IRG with questions or concerns.
Client Alert 2017-282
