“Yates” Grates D&O Value

Implications Are Far Reaching

Can D&O Insurance Protect Officers and Directors Against an Increasingly Aggressive Department of Justice?

BY DAVID WOOD and JOSHUA B. ROSENBERG

On September 9, 2015, the U.S. Department of Justice published a memorandum entitled “Individual Accountability for Corporate Wrongdoing,” authored by Assistant Attorney General Sally Quillian Yates, the product of a working group of prosecutors convened to assess “how the Department approaches corporate investigations” and to identify “areas in which it can amend its policies and practices in order to most effectively pursue the individuals responsible for corporate wrongs.” (Emphasis added.) What became known as the Yates Memo put the corporate community on notice that the DOJ intends to re-focus investigations in criminal and civil matters to target “high-level executives, who may be insulated from the day-to-day activity in which the misconduct occurs.”

The message of the Yates Memo is loud and clear: Criminal prosecutions and civil recovery litigation henceforth will look past the corporate veil and target corporate executives and employees wherever possible. This means more aggressive investigations and claims by the government, and higher attorneys’ and experts’ fees incurred to defend against them.

The Yates Memo contains six measures taken in every investigation of improper corporate conduct:

1. To qualify for cooperation credit in a DOJ prosecution, a corporation must fully disclose “all relevant facts relating to the individuals responsible for the misconduct” (meaning the corporation risks more severe criminal penalties if it shelters executive wrongdoers).
2. Criminal and civil investigations of corporations “should focus on the individuals from the inception of the investigation.”
3. Criminal prosecutors and civil attorneys handling corporate investigations should communicate with one another “to effectively pursue individuals.”
4. Except in rare instances, civil attorneys and criminal prosecutors should not release or grant immunity to individual corporate officers and employees.
5. No investigation of a corporation should be resolved without a clear plan to proceed against individuals.
6. Civil attorneys should focus recovery efforts on individuals, evaluating “whether to bring suit against an individual based on considerations beyond that individual’s ability to pay.”

Corporate executives and boards will want to stand together with the company in responding to government investigations. Good directors and officers (D&O) liability insurance can help promote this strategy.

As the cost of responding to investigations and claims increases, companies and the executives who lead them have been asking for quite some time whether these costs are covered by D&O policies. Until relatively recently, the answer was yes and no. Yes, these costs are covered as long as an individual is targeted in a formal investigation initiated by a complaint, indictment or subpoena. No, these costs are not covered where the investigation is informal or preliminary. The rationale was that in the absence of a demand for monetary relief or redress of a tangible wrong, the D&O policy didn’t provide coverage. In the past decade, however, the soft market for this kind of policy has spawned a number of new D&O products and endorsements extending coverage from costs of responding only to formal investigations, to include the costs of responding to a preliminary investigation or informal request for cooperation.

Targeting Coverage

D&O policies generally are triggered by a “claim” made first against the insured and reported to the insurance company during the policy period. The wording of D&O policies varies significantly from carrier to carrier. With the advent of coverage for the costs of responding to an informal investigation, many definitions of “claim” now encompass civil, criminal, administrative or regulatory investigations once an individual insured is identified, in writing, by the investigating agency as a person against whom a formal proceeding “may be commenced.” While the requirement that the investigation be “formal” generally is gone, an informal request by the government for information and documents may not identify by name any particular individual insured as the target. D&O carriers have proven reluctant to pay attorneys’ fees and costs incurred to facilitate early cooperation with a government agency where no person has been specifically named in the government request. The costs of responding to an informal request for cooperation can be substantial, and there are ways to trigger D&O coverage for them. First, even if such a request does not name an individual, the subject matter of the request may describe a person with sufficient detail to constitute a de facto identification. For instance, suppose the government writes to a company and asks for: (1) all documents relating to the sale of a particular product to a foreign nation; (2) documents, including general ledger entries, reflecting all consideration booked by the company for the sale; (3) documents reflecting value of any kind provided by the company to any person or company other than its employees to induce or facilitate the sale; (4) the name of the senior vice president in charge of the division that made the sale; (5) all documents, including the senior vice president’s employment contract, stating how his year-end bonus is calculated; and (6) the amount of the senior vice president’s bonus in the years the sale was pending and closed, and how much of the bonus was attributable to the particular sale. A reasonable argument can be made that this request is the opening salvo of an investigation of this senior vice president for possible violations of the Foreign Corrupt Practices Act, and that the identity of the targeted individual is obvious and can be no one else.

Second, even if a request is vague as to an individual target, extrinsic evidence may identify the person sufficiently to trigger coverage. Suppose in the previous example the government requests the names of all employees involved in the sale of the product who had decision-making authority and interacted in person or in writing with decisionmakers at the foreign nation. If evidence extrinsic to the request shows that the SVP is the only employee who fits this description, there is a reasonable argument that D&O coverage has been triggered. (See e.g., Jemmco v. Executive Risk Indemnity, Docket No. L-486-07 (N.J. Superior Ct., filed March 22, 2007) [court found sufficient affidavit from insured’s counsel stating that he had seen the formal investigate orders, which were not public, when he met with lawyers from the Securities and Exchange Commission and others]; Ace American Ins. Co. v. Ascend One Corp., Docket No. 1:06-cv-0337-CCB (D. Md. August 7, 2008) [allowing evidence extrinsic to a subpoena to prove “wrongful acts” were being asserted against insured].)

The third and most obvious way to ensure coverage under this example is to have the broker ask the underwriter on inception of the policy or at renewal to endorse the policy to make clear that the identification requirement is satisfied where the individual is named or can reasonably be identified in the writing that initiates the covered civil, criminal, administrative or regulatory investigation.

Wedge Issues

The Yates Memo also advises that—absent extraordinary circumstances or departmental policy interests—resolution of an investigation against a company should not result in a release of or immunity for individual directors or officers accused of wrongdoing. By incentivizing companies to make a speedy and complete disclosure of information about its directors or officers’ potential wrongdoing, the Yates Memo exacerbates a simmering conflict of interest in most D&O insurance programs.

D&O insurance policies are commonly written on an aggregate limits basis, which means the limits of the D&O insurance program are available for any and all claims. Thus, any claim will erode the limits of the policies available to pay other claims that are being made or allocated to the particular policy period. This can create conflicts of interest between a company and its directors and officers when their respective interests are not aligned. Where companies may be quick to cooperate with a government investigation, individual directors and officers may lack the same incentive.

Sharing limits between the corporation and the individual insureds may exacerbate this conflict. The best way to avoid this is to buy one set of limits covering the corporation, and a set of separate or excess limits for the individuals. Other wedge issues concern self-insured retentions and application issues. Generally, D&O policies have three insuring agreements—known as Side A, Side B and Side C— which define the carrier’s promises to its policyholders. Side A covers the personal liability of the individual directors and officers when the corporation is not permitted or is financially unable to indemnify them for a claim against them arising from execution of their duties. Where the corporation is permitted and able to indemnify its directors and officers, Side B covers the losses sustained by them (defense expenses, settlements and judgments) to the extent that the company indemnifies them.

Side B does not cover the direct liabilities of the corporation— Side C does. Side C coverage often is limited to the company’s liability associated with its own securities, and is intended primarily to respond to Rule 10b-5 actions and other shareholder litigation.

For corporate officers and directors, the most important piece of a D&O policy is Side A, representing the final bulwark against claims of liability against them personally. When their company can’t indemnify them, Side A is their only source of protection for their personal assets. Most corporations purchase Side A coverage that is not subject to any self-insured retention to ensure that their directors and officers need not pay a retention as a condition to coverage, unlike the corporation must do under Sides B and C.

Also, corporations regularly purchase Side A coverage that is non-rescindable. In most states, if an application for insurance includes an intentional misrepresentation of a material fact, on which the carrier relies in selling the policy, the insurer can rescind the policy by giving back the premium and acting as if the insurance contract had never been made. In some states, such as California, the misrepresentation doesn’t have to be intentional—a merely mistaken representation, if it’s material and the insurer relies on it, is enough to rescind coverage. A D&O policy that has non-rescindable Side A coverage—meaning that rescission of Side A applies only to individual insureds who knew of the misrepresentation— protects good directors and officers by preventing an insurer from walking away from the insurance contract because of a single director or officer’s misrepresentation.

A year out from issuance of the Yates Memo, it’s too soon to tell whether and to what extent a government campaign to more aggressively target individuals has happened yet. But the DOJ has said what’s coming, and there is no reason to doubt its resolve. To adjust to this threat, directors and officers not only need to adhere to a higher standard of care, they also need to review their D&O policies to see if they are carefully tailored to meet the costs of defending and resolving claims of breach of this higher standard. Desirable policies will cover the cost of answering preliminary requests for documents and information even where no target is named, and will have Side A coverage that is subject to separate limits, is non-rescindable and subject to a zero-cost retention.

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David E. Wood is a partner in the Los Angeles office of Barnes & Thornburg LLP, where he is a member of the Insurance Recovery and Counseling Practice Group. With more than 30 years of experience in the insurance field, Mr. Wood devotes his practice to advising and representing publicly and privately owned corporations in insurance recovery matters.

Joshua B. Rosenberg is an associate in Barnes & Thornburg’s Los Angeles office. He is a member of the Litigation Department and the Insurance Recovery and Counseling Practice Group.