Corporate directors and officers litigation today often involves claims asserted under the federal securities laws as well as under federal employee-benefits law (ERISA). The plaintiffs in these suits are conceptually different: securities-law plaintiffs are people who (and entities that) purchased or sold the company’s securities; ERISA plaintiffs are participants in employee-benefit plans that held or permitted the investment in company securities. Increasingly, ERISA cases are tagging along to securities cases: the directors and officers (who often are plan fiduciaries) are alleged to have failed to disclose certain facts about the company’s operations or finances to the market generally (for securities claims) or to participants in company-sponsored employee-benefit plans (for ERISA claims).
The United States Court of Appeals for the First Circuit recently had the opportunity to address coverage for a tagalong ERISA claim that was made four years after a securities-law class action was filed. In a very troubling opinion, the court ruled that no coverage was available for the ERISA class action because the gravamen of the complaint echoed the allegations in the earlier securities class action. The basis of the court’s ruling was not that the policyholder had failed to disclose the early securities-law class action, but rather that a generic prior-and-pending litigation exclusion barred coverage. Federal Ins. Co. v. Raytheon Co. (1st Cir. Oct. 21, 2005)
Prior-and-pending exclusions take one of two forms: a laser-beam exclusion that bars coverage for prior claims that are listed by name in the exclusion and a generic exclusion that bars coverage more generally if a claim subsequently made in the policy period is related to a prior claim. This was the type of exclusion at issue in Raytheon. In particular, the language provided:
The Company shall not be liable for Loss on account of any Claim made against any Insured . . . based upon, arising from, or in consequence of any demand, suit or other proceeding pending, or order, decree or judgment entered against any Insured, on or prior to [policy inception], or the same or any substantially similar fact, circumstance or situation underlying or alleged therein.
This is a reasonably standard version of the generic prior-and-pending exclusion that is found in many corporate policies today.
In Raytheon, there was no dispute that at least some of the allegations in the ERISA class suit had been cut and pasted from the securities class action. The dispute centered on how much overlap must there be between the two cases for the prior-and-pending exclusion to apply.
The court focused on the pivotal language in the exclusion, which is that, for the exclusion to apply, the claim in the policy period must be “based upon . . . the same or any substantially similar fact, circumstance or situation underlying or alleged therein.” The court found that the use of the term “base” meant that “situations in which the complaint in the second action does not draw substantial support form the allegations of the first” were not within the purview of the exclusion (slip op. at 17); however, the exclusion is not limited to only those claims where the “first action provide[s] the sole support for the second.” Id. Instead, the court held:
We think that the policy thus requires the allegations in the second complaint find substantial support in the first complaint, i.e., that the allegations of the second complaint substantially overlap those of the first. [For the exclusion to apply] the second complaint [must] substantially overlap the first with respect to relevant facts.
Slip op. at 17-18.
The court stated that its construction promoted the purposes of the prior-and-pending exclusion: (i) to encourage insureds to give prompt notice; (ii) to avoid stacking policy limits in successive policies; and (iii) to discourage insureds from purchasing policies knowing that claims were going to be asserted (avoiding the “adverse selection” problem). Slip op. at 18-19.
But the court’s construction does not provide an incentive for providing prompt notice – in Raytheon, there was nothing for the insured to give notice about to its ERISA liability carriers when the securities case was filed three years earlier. No ERISA claim had been made, and even if notice had been given at that time to the ERISA carriers that year, they would have had no obligations – their policies had not been triggered since no claim had been made. (Even if in the policy in effect at the time of the securities claim there was a notice-of-circumstances provision, which is an extension of coverage by which the insured at its option can lock-in coverage for post-policy period claims if it first discovers during the policy period circumstances that later may lead to claims, the insured probably would not have been able to avail itself of this protection due to the stringency of the requirements of such provisions.) Accordingly, the rationale to stimulate early notice is entirely misplaced.
The second rationale, to avoid the stacking of policy limits, is in many ways a restatement of the first – stacking results when a claim is made in year 1 and a second, related claim is made in year 2, such that the policyholder can collect under each policy for the claim made in that year. There is at a minimum a dispute in the case law whether claims-made policies permit this result in the first place, that is, whether they permit the second policy even to be triggered from the assertion of a new but related claim in year 2; many commentators and courts believe that all subsequently related claims relate back to the first claim (since most policies define claim to include a “series” of claims) such that “the” claim was “first made” in year 1. One can debate whether claims-made or claims-first-made policies really work this way as they are written, but there is certainly a large number of insurers and commentators that believe that all subsequently asserted claims relate back to the first year, such that by design there is no cumulation or stacking of policy limits. But even under this view, crucially the policyholder gets paid for the second claim under the first year’s policy. Under the First Circuit’s ruling, the policyholder does not get paid at all for the second claim.
And none of this examines whether stacking or cumulation of policy limits is something that should be avoided. There are certainly substantial arguments in terms of risk spreading and the marginal utility of (insurers’) money that support stacking policy limits; the correct analysis is to look at the obligation of each carrier separately under its contract, to recognize that it was paid a full premium for the limits it provided, and to consider the axiom that successive carriers are not third-party beneficiaries of prior coverage.
At all events, the court’s second rationale – the avoidance of stacking – is unpersuasive (or surely it is inadequately explained or justified).
The First Circuit’s third rationale is similarly unconvincing. The third justification is that it avoids “adverse selection,” that is, the propensity of those with a higher exposure to loss to seek insurance protection. Here, too, the court’s facile invocation of insurance-speak (which arguably it does incorrectly) obfuscates rather than clarifies the analysis. What must be first recognized is that by their nature claims-made policies are retrospective in the coverage they provide – in other words, they are designed to cover past events, and the insured-against contingency is whether or not a claim will be made in the particular policy year. There is no showing at all in Raytheon that the company thought an ERISA claim would be brought at all let alone in the policy year in question. More importantly, this all underscores that the way to police the so-called adverse selection problem is through underwriting. Insurers are supposed to gauge for themselves the likelihood that a policy they are considering issuing may be forced to pay out, and the underwriters have the ability to ask for information and make that assessment (or take a risk against not having adequate information). If the policyholder did not adequately respond to the underwriters’ inquiries, then the policy may be voided on nondisclosure or misrepresentation grounds. What the First Circuit’s ruling does is not to police adverse selection (bad policyholders seeking coverage) but rather encourages bad and lazy underwriting – ironically as respects policies whose very purpose is to provide retrospective coverage.
Indeed, the court does not take into account that, because they provide coverage retrospectively, claims-made policies typically include a “retro date,” that is, a provision stating that the operative events leading to a claim in the policy period must take place on or after a particular date (often, the inception date of the first policy issued by the carrier to that insured). This is significant because the Raytheon court’s construction sub silentio adds an additional retro-date limitation, barring coverage for past factual circumstances that are substantially similar to misconduct undergirding any prior claim made under any type of policy.
Worse, it is not unreasonable to assume on the facts that Raytheon did disclose the existence of the prior securities-law class action; it was still pending at the time of the ERISA fiduciary policy’s inception. In the circumstances, that the insurance company did not laser-beam out any subsequent claims arguably induced the policyholder to believe there would be coverage.
While the Raytheon court uses its three policy rationales to buttress its holding, it is true that they are not necessary to the court’s ruling, which is predicated on a construction of the policy language, especially the meaning of “based upon.” While we must start the analysis with the policy language, and where the language is plain it will be applied, there remains a governor on the plain-meaning rule, which is that the result must still pass a reasonableness test. There are different ways this notion is expressed: a policy will not be construed to achieve absurd results is one formulation. Here, the result in Raytheon fails any type of reasonableness review.
To illustrate, the following propositions are all supported by the facts described in the Raytheon opinion:
a. The policyholder made adequate disclosure of the securities case in the underwriting;
b. No policy is triggered until the assertion of a claim against the policyholder;
c. The constellation of plaintiffs, legal claims and theories, and remedies are different in the securities and the ERISA cases.
The Raytheon court’s ruling means that the fiduciary-liability policies never have an obligation to respond to a follow-on ERISA case that is made in any year other than the year that the securities case is brought. In other words, unquestionably had the ERISA case been filed soon after the securities case, the fiduciary-liability carriers that year would have been required to respond. But if the ERISA case is filed the next year (or thereafter), the fiduciary-liability carriers in those years will not need to respond by dint of the generic prior-and-pending exclusion.
So, where does this leave policyholders, which are increasingly facing tagalong ERISA claims to securities cases filed against their directors and officers (who often are benefit-plan fiduciaries)?
1. The Raytheon court suggests that if the policyholder wishes to preserve coverage it in effect should provoke the filing of the ERISA tagalong within the same policy year that the securities case is filed. (Similarly, plaintiffs need to be aware of the Raytheon holding and file the ERISA case promptly to assure that insurance monies may be available to fund any settlement or judgment; thus, the court’s ruling stimulates the filing of claims that might otherwise not be brought at all.)
2. Policyholders should resist “generic” prior-and-pending exclusions and demand that carriers laser-beam out matters that will be excluded if a related claim is asserted later. While this may result in carriers’ seeking to exclude by name the three-year-old securities claim in Raytheon, the policyholder will have the opportunity to buy back that exclusion and, if not, to know with certainty whether there will be coverage for a tagalong ERISA case.
While I believe that generally speaking the latter result is salutary, it is an unintended consequence of the First Circuit’s decision and surely is not sufficient to justify what is otherwise an untenable holding and the untoward effects it causes. Insureds face increasing risk of tagalong ERISA claims; insurers are willing to provide coverage for that risk; and in the absence of plain and compelling policy language courts should be more reluctant to take boilerplate, general exclusions and gut crucial protection that policyholders believed they paid for.