by Christopher Graham and Joseph Kelly

Today’s story: You’re a bank director. Your bank has a D&O policy. The policy has no regulatory exclusion. “That’s good,” you say. “One less worry. Although I can’t imagine it would ever happen, at least I know I have coverage for claims by the FDIC if the bank ever were to fail.”

Later, although once unthinkable, your bank does fail. And the FDIC blames you and other directors and officers for losses. Then it sues you and them. Bad news.

Then bad news becomes worse. Your D&O insurer. You know, the one issuing the policy without the regulatory exclusion. It now says, “Sorry, but these FDIC claims aren’t our problem. Yes, this policy has no regulatory exclusion. But it has an insured versus insured or IVI exclusion. So no defense from us! No other coverage from us!”

Groundhog day: Does this sound familiar? If you’re a regular reader, it does. You’ve seen two Groundhog day posts like this recently. Wake up, same post, with twists. Wake up, same post, with twists.

As detailed here, letting a D&O insurer avoid coverage for FDIC claims against directors and officers, a Kansas Federal Judge in Bancinsure v. McCaffree, et al, Case No. 12-2110-KHV (D. Kan. Feb. 27, 2014), now on appeal, didn’t care about an endorsement removing a regulatory exclusion. And as detailed here, allowing another D&O insurer to avoid coverage, a California magistrate in Hawker v. Bancinsure, Case No. 1:12-cv-01261 (E.D. Ca. Apr. 7, 2014), didn’t care about a regulatory exclusion dropped from a renewal policy. All that mattered was an IVI exclusion for claims by a “receiver.” So insurer won.

Now we have another failed bank. Another D&O policy without a regulatory exclusion. Another D&O policy with an IVI exclusion. Another FDIC suit against directors and officers. And another court decision, W Holding Company, et al v. AIG Insurance Company – Puerto Rico, Case No. 12-2008 (1st Cir. Mar. 31, 2014), applying the exclusion to FDIC claims. It’s Groundhog day with twists, just like the movie!

Twist #1: This time the D&O insurer Chartis lost an initial battle in the Puerto Rico Federal District Court and First Circuit. The insurer must advance fees to defend FDIC claims, albeit without waiving a right to repayment.

Twist #2: This insurer issued other policies with a regulatory exclusion. But not this one. The IVI exclusion said:

[The insurer] shall not be liable to make any payment for Loss in connection with any Claim made against an Insured . . . which is brought by, on behalf of or in the right of, an Organization or any Insured Person other than an Employee of an Organization, in any respect and whether or not collusive.

“Insured” meant the “Insured Person,” including directors and officers, or “Organization,” including the bank and its holding company. Insurer argued FDIC’s claims were “brought . . . on behalf of or in the right of, an Organization”–namely, the failed bank–and so the exclusion applied.

The IVI exclusion said nothing about applying to claims by a “receiver” unlike the exclusions in the Kansas and California cases. Unlike those exclusions, moreover, this exclusion applied to a Claim made against an insured “whether or not collusive.” (Emphasis added).

Twist #3: According to the policy, insurer “must advance defense costs, excess of the applicable retention, pursuant to the terms herein prior to the final disposition of a claim.” And in a similar vein, insurer “shall advance, excess of any applicable retention amount, covered Defense Costs,” including “reasonable and necessary fees, costs and expenses consented to by the Insurer.” Loss under the insuring agreement also included Defense Costs.

The directors and officers moved for an order requiring insurer to advance defense costs. But they stated, “This is not a preliminary injunction motion” and then, per the court, they argued:

that (a) they would be irreparably harmed if their motion failed, because many of them are “elderly,” “unemployed,” “retired,” and “living on fixed incomes,” and so cannot shoulder the defense costs; that (b) [insurer’s] duty to advance defense costs to them is plain as day; and that (c) the public’s interest in making sure that insurers keep their commitments and that insureds get what they paid for cannot be questioned.

As the court explained, those points typically are argued when seeking a mandatory preliminary injunction, which

typically depends on the exigencies of the situation, taking into account four familiar factors: the moving party’s likelihood of success on the merits, the possibility of irreparable harm absent an injunction, the balance of equities, and the impact (if any) of the injunction on the public interest.

In addressing insurer’s appellate argument about the merits factor, the appeals court stated:

When it comes to the merits, [insurer] stakes everything on persuading us that the directors and officers are not likely to succeed on their coverage claim and so should not get cost advancements. Given this development, we need not concern ourselves with the other elements of the four-part test

In the Kansas case, insurer advanced fees, subject to a reservation of rights. So the directors and officers didn’t need an order compelling advancement. In the California case, FDIC and directors and officers settled, by consent judgment and assignment; so the battle was between FDIC and D&O insurer about coverage for that judgment and advancement wasn’t an issue.

Twist #4: Puerto Rican law set a very low bar for showing advancing fees was required:

[A]n insurance company must advance defense costs if a complaint against an insured alleges claims that create even a “remote possibility” of coverage. . . . Think about that for a second. Not an “actuality” of coverage. Not even a “probability” of coverage. No, a mere “possibility” of coverage will do — regardless of how “remote” it may be. A pretty low standard, indeed.

Further:

On top of that, courts must read the complaint’s allegations “liberal[ly]” when doing a remote-possibility check. . . . . Also, any doubt about an insurer’s advancement obligation “must be resolved in the insured’s favor.” . . . . Seemingly what animates these rules “is that the purpose of insurance policies is to provide protection for the insured.”

The court’s comments above are similar to what courts in many states say about how to determine whether an insurer has a duty to defend under a policy including that duty.

So did the FDIC’s complaint allege claims creating a “remote possibility” of coverage?

Yes, says the court, with this explanation:

[T]he FDIC did more than allege that it had succeeded to [bank’s] rights. It also alleged that it had succeeded to the rights of [bank’s] depositors and account holders — rights that included the right to “bring this action.” And it alleged, too, that it was suing to recover money the FDIC-insurance fund had shelled out after the bank had shut down. Eyeing that pleading liberally, . . . while knowing also that pleading perfection is not required, . . . we think that these allegations make it likely possible — even if only remotely so — that the FDIC is suing on these non-insureds’ behalf.

FDIC’s second amended complaint alleged that, as receiver, it “succeeded to all rights, claims, titles, powers, privileges, and assets of [bank] and its stockholders, members, account holders, depositors, officers, or directors of [bank] with respect to the institution and the assets of the institution, including the right to bring this action against the former officers and directors of [bank].”

The FDIC, per the court, also relied on the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, providing:

[FDIC] shall, as . . . receiver, and by operation of law, succeed to . . . all rights, titles, powers, and privileges of the insured depository institution, and of any stockholder, member, account holder, depositor, officer, or director of such institution with respect to the institution and the assets of the institution. (12 U.S.C. § 1821(d)(2)(A)(i)).

The IVI exclusion applied only to claims “brought by, on behalf of or in the right of, an Organization or any Insured Person other than an Employee”–not to claims brought “on behalf of or in the right of” account holders and depositors, or for the FDIC-insurance fund.

Although insurer argued otherwise, this court said it was irrelevant that FDIC failed to explicitly identify these various roles in its initial demand letter; there was no law requiring it to do so.

FDIC’s multiple capacities under “FIRREA” weren’t addressed in the Kansas and California opinions. Nor was advancement an issue, as explained earlier.

Twist #5: For a preliminary injunction requiring advancement, the directors and officers need only prove a “likelihood of success on the merits” and “remote possibility” of coverage. This, as the court explained, was an easy hurdle:

Looking at the cost-advancement issue through the prism of preliminary-injunction principles makes an already insured-friendly situation under Puerto Rico law friendlier still. At this stage, you see, the directors and officers need not show a “certainty” of a “remote possibility” of coverage. On the contrary, only a “likelihood” of a “remote possibility” of coverage is required.

Further:

With no controlling [Puerto Rico] authority on whether an insured-versus-insured exclusion applies to the FDIC in a situation like ours; with non-binding cases pointing in different directions; and with our obligation to resolve any doubts in the insured’s favor, . . . — [insurer’s] suggestion that there is zero likelihood of a remote possibility of coverage falls flat. Keep in mind (and we cannot stress this enough): likelihood — not certainty — is the name of the game, and possibility — not actuality or probability — suffices, no matter how remote that possibility is. And that standard is met here.

Twist #6: FDIC sued the directors, officers and, because Puerto Rico had a so-called direct action statute, their D&O insurers. Insurers moved to dismiss FDIC’s claims as barred by the IVI exclusion. But the district court denied the motion. See W Holding Co., Inc., v. Chartis Insurance Co.-Puerto Rico, 904 F.Supp.2d 169 (D. Puerto Rico 2012). Per the appeals court:

[T]he [district] judge said that the insured-versus-insured exclusion barred the FDIC from suing on behalf of [bank’s] members, officers, and directors, plus also [bank’s] shareholders (consisting only of W Holding, a party to the case). But because the FDIC also sued on behalf of account holders, depositors, and the drawn-down FDIC-insurance fund, the judge concluded that the FDIC’s claims fell outside the insured-versus-insured exclusion.

But the appeals court didn’t decide whether the IVI applied to FDIC’s claims. It only decided there was a “likelihood” of a “remote possibility of coverage.” That’s all that was needed to affirm the order requiring fee advancement. As the appeals court stated: “[L]est anyone be confused — that having lost the likelihood-of-success skirmish, [insurer] may still ‘win’ the coverage ‘war at a succeeding trial on the merits.'”

The order, requiring advancement, deemed a mandatory preliminary injunction, could be appealed immediately; so that was appealed and addressed. The order denying insurers’ motion to dismiss FDIC’s claims couldn’t be appealed immediately as of right; and the appeals court didn’t decide if that order was right or wrong.

Comments: So what are some takeaways:

Preliminary injunction motions for advancement: Where there’s a financial catastrophe such as a bank or business failure, directors and officers may face enormous defense fees exposure. If their insurer doesn’t pay or defend, motions for a mandatory preliminary injunction may force an insurer to pay or defend. As in this case under Federal law, it’s a way to get an immediate order requiring proof of only a “likelihood of success on the merits” and of allegations only potentially within the scope of coverage.

But the strategy doesn’t always succeed. Chris, the “old guy” author of this blog, was lead insurer counsel in Anglo-American Insurance Co. v. Molin, 547 Pa. 504 (1997). There, the Pennsylvania Supreme Court reversed a mandatory preliminary injunction requiring Lloyd’s underwriters to advance fees for defending claims by Pennsylvania’s insurance commissioner against a failed life insurance company’s directors and officers.

Dropped regulatory exclusions; kept IVI exclusions: Bank D&O insurers, including this one, had a very straight-forward way to exclude FDIC claims against bank directors and officers–namely, regulatory exclusions. But, for whatever reason, some insurers, at least for a time, didn’t include them in their policies.

During the financial crises of the 80’s and 90’s, insurers largely won the battle with FDIC about whether regulatory exclusions were against public policy. Many Federal appeals courts said they were not. So we were somewhat surprised, especially the “old guy,” Chris, who worked professionally through those times, that bank D&O insurers dropped regulatory exclusions. They’re ordinarily a very direct way to avoid limits claims from a bank failure. It was especially surprising given the hits the industry experienced from bank and S&L failures back then. Short memories?

So why were regulatory exclusions dropped? More players in the market? More competition? More insurers dropping the exclusions? Harder to sell D&O policies with regulatory exclusions? Do what’s necessary to meet the market, sell the policy, and book the premium? And we can exclude catastrophic risk from a bank failure, albeit with less direct wording? Maybe no impact on selling policies?

Before the you-know-what-hit-the fan, did it occur to buyers and brokers of bank D&O insurance that having purchased a D&O policy without a regulatory exclusion, their insurers would raise IVI exclusions as grounds for denying coverage for FDIC claims following a bank failure?

Or that, as in the California and Kansas cases, IVI exclusions that ordinarily didn’t refer to claims by a receiver, would be modified to do so, so the insurer could argue FDIC claims following a bank failure were excluded?

Or, as in this case, that an insurer would argue FDIC’s claims were “brought . . . on behalf of or in the right of” the failed bank and, thus, fall within an IVI exclusion?

Or that insurers would argue and, at least some courts would agree, that removal meant only that claims by FDIC in a corporate capacity would be covered? While claims presenting the greatest risk to the personal assets of bank directors and officers, namely, FDIC claims as a failed bank’s receiver, would not? Isn’t that a risk any community banker would have wanted and expected their D&O insurer to cover? How much of a real risk is presented by claims by FDIC in a corporate, rather than receivership capacity?

Was anyone thinking that their insurers would argue later that removing a regulatory exclusion, as a practical matter, would result in no material expansion of coverage?

Were IVI exclusions referring explicitly to claims by a “receiver” in policies issued to big banks? Or just community banks, such as in the Kansas and California cases?

Were the brokers, risk managers, and bank directors and officers paying attention to the wording idiosyncrasies of IVI exclusions? They better be thinking about them now!

Tags: Puerto Rico, 1st Circuit, D&O, directors and officers liability insurance, management liability insurance, FDIC, “insured vs. insured” exclusion, insured versus insured exclusion, IVI exclusion, regulatory exclusion, advancement, mandatory preliminary injunction