Fiduciary Liability Insurance for the Credit Crisis

Transcription

1 Looking for Coverage By John W. Egan and Michael C. Cannata Fiduciary Liability Insurance for the Credit Crisis Insurance implications for the financial services industry of recent ERISA class actions against pension plans, trustees, directors and officers. The financial and credit crisis has had a devastating impact on the value of 401(k) and other pension plans. These accounts have lost approximately $2 trillion in value as a result of declining stock value. Associated Press, Financial Crisis Drains Retirement Plans (Oct. 7, 2008). Employees and participants in employee benefit and pension plans have recently filed class action lawsuits under ERISA. These actions assert claims against the companies sponsoring pension plans, individual directors and officers, as well as plan trustees. Defendants in these actions will look to their insurance carriers for coverage for these claims. Recently Filed ERISA Class Actions The target of these ERISA suits are financial institutions that invested heavily in subprime mortgages, collateralized debt obligations, and other risky investments. The employees of these financial institutions that participated in company pension plans allege that the committees overseeing these plans, and the individual members of these committees, breached fiduciary duties under ERISA. Specifically, these complaints allege that the defendants continued to invest plan assets in company stock even as the credit crisis continued to unfold. These actions involve well-recognized financial institutions, such as Indymac Bank, UBS, Wachovia, AIG, and Lehman Brothers, and include the following: A class action by participants in the Lehman Brothers Savings Plan under ERISA, naming Lehman Brothers Holdings, Inc., the individual directors of Lehman Brothers, and the individual fiduciaries of the plan as defendants. Rinehart, et al. v. Lehman Brothers Holdings, Inc., et al., Index No.: (S.D.N.Y). The participants allege that defendants imprudently invested plan assets in company stock, even after it became clear to corporate executives that the company was suffering a sharp revenue decrease as a result of its heavy and improvident investments in collateralized debt obligations and subprime mortgage-backed derivatives. A class action by participants in the UBS Financial Services Inc. 401(k) Plus Plan under ERISA, naming as defend- n John W. Egan and Michael C. Cannata are associates with Rivkin Radler LLP in Uniondale, New York, practicing in the firm s Insurance & Coverage and Commercial Litigation Practice Group. Mr. Egan is a member of DRI s Young Lawyers Committee. This article presents the views of the authors. This article is not intended to present the views of Rivkin Radler LLP or any client of Rivkin Radler LLP. 34 n For The Defense n February DRI. All rights reserved.

2 ants UBS, the 401(k) Plus Plan, individual members of the Benefits Committee, and individual members of the board of directors of UBS. Stanislaus, et al. v. UBS, et al., Index No.: (S.D.N.Y). The complaint alleges that the defendants breached their fiduciary duties by allowing heavy, imprudent investment of Plan assets in UBS Stock throughout the Class Period despite the fact that they knew (or should have known) that such an investment was unduly risky and imprudent. Two class action lawsuits by participants in the IndyMac Bank, F.S.B. 410(k) Plan under ERISA, naming as defendants IndyMac, as well as individual directors, officers and pension plan fiduciaries. Wang, et al., v. IndyMac Bank, F.S.B., et al., Index No.: (C.D. Cal.); Sandoval et al. v. IndyMac Bank F.S.B., et al., Index No.: SACV (C.D. Cal.). Both complaints assert that the defendants breached fiduciaries duties under ERISA by investing plan assets in IndyMac, despite the bank s extensive involvement in Alt-A loans and other nontraditional and risky mortgage products. A class action by participants in two AIG pension plans under ERISA, naming as the defendants AIG, the plan administrator, AIG directors and officers and members of the employee benefits committee. Mass, et al., v. American International Group, Inc., et al., Index No.: (S.D.N.Y). It is alleged that AIG undertook improper activities to artificially inflate the value of AIG stock, and that defendants continued to invest plan assets in these stocks resulting in substantial losses to the pension plans. A class action by participants in the Wachovia Savings Plan under ERISA, naming as defendants Wachovia, members of the board of directors, the resources and compensation committee, the human resources division, and the benefits compensation committee. Wright v. Wachovia Corp., et al., Case No. 08 Civ (DC) (DF). The complaint alleges that the defendants continued to invest plan assets in Wachovia stock despite the company s over-investment in collateralized debt obligations, residential and commercial mortgage-backed securities, and other precarious investments. These ERISA Class Actions Assert Claims against Individual Defendants Under ERISA, corporations that take responsibility for employee pension and retirement plans are obligated to manage these plans in the best interests of plan participants. ERISA provides for personal liability against individuals that breached fiduciary duties with respect to these plans. See John Conley, Bear Fright; Market Fear, Fiduciaries Risk Management (Sept. 1, 2000). Fiduciary is broadly defined under ERISA. A fiduciary is not necessarily limited to appointed trustees or other individuals retained to invest and manage a plan. Any person with discretionary authority over the plan is considered a fiduciary and is potentially liable under ERISA. The statute defines a fiduciary as a person who exercises any discretionary authority or discretionary control respecting management of [a] plan or exercises any authority or control respecting management or disposition of its assets. 29 U.S.C. 1002(21)(A). Therefore, in addition to the trustees or other individuals expressly retained to oversee the investments of the pension plan, ERISA imposes a legal obligation on any person who exercised discretionary control or authority with respect to the plan. Such persons may include independent directors or officers of the company sponsoring the plan, as well as lawyers, accountants, insurance brokers, or investment advisors. Mark A. Hoffman, Fiduciary Liability Suits Increasing, Professional Liability Underwriting Society Conference (Crain Communications, Inc., Nov. 25, 2002) Individual directors or officers are named as defendants in each of the ERISA class actions mentioned above. On the face of these complaints, these directors or officers were not alleged trustees or named fiduciaries of the pension plans. Instead, several of the complaints claim that these defendants are de facto fiduciaries, as broadly defined by ERISA, based on their discretionary authority or control over the plans. Recent ERISA Claims in Context: Emergence of the Tag Along Fiduciary Liability Lawsuit Fiduciary liability lawsuits, and insurance claims accompanying them, have increased in recent years. Following the corporate scandals of the early part of this decade, representatives of pension plans have increasingly brought claims alleging that the trustees of the plans, and other fiduciaries, breached their fiduciary obligations under ERISA. Joanne Sammer, Is Fiduciary Liability Insurance the New D&O?, Business Finance (Jan. 1, 2004). This increase in ERISA claims against Several of the complaints claim that these defendants are de facto fiduciaries based on their discretionary authority or control over the plans. plan fiduciaries is attributable to the emergence of what has been described as the tag along ERISA class action. Specifically, these lawsuits are filed on the heels of securities actions brought against the same defendants, with similar or identical allegations. See Best Wire, Experts Cite Increasing Claims for Fiduciary Liability, (Mar. 8, 2004). These class actions target employee benefit plans invested in company stock. See Sammer, supra. Both the securities and ERISA actions allege, for example, that officers and directors of the company made misrepresentations in accounting documents, or failed to disclose adverse information concerning the financial well-being of the company. See id. A tag along ERISA action typically asserts that these individual defendants violated ERISA by making these misrepresentations and omissions to plan participants, as well as to shareholders, by virtue of their participation in the pension plan, and by continuing to invest plan assets in the company s stock. The emergence of the tag along ERISA lawsuit has resulted in increases in premiums and self-insured retentions for fiduciary liability coverage among some carriers, as these lawsuits require a sophisticated defense and are costly to settle. Id. For The Defense n February 2009 n 35

3 Several recently filed pension plan class actions continue this trend. ERISA actions have been filed against financial institutions that are already subject to derivative securities actions. For example, both ERISA and securities class actions have been filed against Lehman Brothers. The securities litigation, as with the ERISA action, allege that the defendants, including individual Policies do vary and should be individually examined to determine the scope of insurance coverage. directors and officers of Lehman Brothers, made misrepresentations during the class period that the company was financially strong and its liquidity position was solid despite the difficult environment for the financial services industry. See Market Wire, Saxena White P.A. Files Shareholder Suit against Lehman Brothers Holdings Inc. (Jun. 18, 2008). Additionally, ERISA and securities actions have been filed against AIG, the latter alleging that directors and officers of AIG should be held personally liable for violating federal securities laws. Practical Accountant, 41 Profession Watch 11 (November 2008). Insurance Coverage for ERISA Lawsuits In light of these recent ERISA claims against pension plan fiduciaries, including directors and officers of the corporations sponsoring these plans, practitioners should become familiar with the different lines of insurance potentially applicable to lawsuits arising from the investment, management, and oversight of employee benefit and retirement plans. Fiduciary liability policies typically apply to ERISA claims. These policies are intended to cover liabilities arising from the discretionary judgment of plan trustees in connection with investment of plan assets. Richard Clarke, Fiduciary Liability 36 n For The Defense n February 2009 Pitfalls and Solutions, 20 The Risk Report 7 (March 1998), p. 2. However, other coverage sources or lines of insurance may also apply when lawsuits are filed in connection with the management of a pension plan. ERISA mandates employers sponsoring these plans procure fidelity bonds, known as ERISA bonding, to apply to liability if a dishonest trustee or plan administrator causes financial harm to the plan. See 29 U.S.C Such acts of dishonesty are generally excluded from coverage under traditional fiduciary liability insurance. Further, employee benefit liability insurance applies to losses due to ministerial acts, as opposed to breaches of fiduciary duties, by administrators of a pension plan. Coverage under these policies extends to errors and omissions, rather than to the exercise of judgment generally covered by a fiduciary liability policy. A lawsuit claiming that a plan administrator failed to enroll an employee in a company plan, for example, may constitute an omission falling within the scope of a standard employee benefit liability policy. These policies do vary, however, and should be individually examined to determine the scope of insurance coverage. As mentioned above, ERISA and securities lawsuits arising from the credit crisis are being asserted against individual directors and officers. However, regarding claims that individual defendants breached fiduciary duties under ERISA, these allegations are generally excluded by the terms of directors and officers ( D&O ) policies. These policies typically exclude losses if the insured served in any fiduciary capacity under ERISA, or under any other similar federal, state or local statute. It should be noted that fiduciary liability coverage is not limited to stand-alone policies. This type of coverage may also be included as endorsements in a wide variety of policies. Specifically, fiduciary liability coverage endorsements may be included in D&O, commercial general liability, professional liability, and errors and omissions policies. Coverage Issues Prior Acts Exclusion Fiduciary liability policies are claimsmade policies, distinct from occurrence policies. Many commercial general liability ( CGL ) policies are based on the occurrence model; coverage is triggered by an injury occurring during the policy period. Coverage under a claims-made policy applies when a claim is made against the insured during the policy period. For coverage to apply under fiduciary liability policies, a claim must be first made during the policy period. As with many D&O policies, fiduciary liability policies include what is often referred to as a prior acts exclusion. This exclusion may eliminate coverage for any claim alleging, arising out of, based upon or attributable to any claim which has been reported under a prior policy. Matthew Bender, 2-25 Liability of Corporate Officers and Directors 25.16, quoting National Union Policy Form (Ed. 5/95). This exclusion may be implicated by tag along ERISA class actions. A prior acts exclusion, in connection with similar ERISA and securities claims, was at issue in the decision of the District Court for the Southern District of New York in Zahler v. Twin City, 2006 U.S. Dist. LEXIS (S.D.N.Y. Mar. 30, 2006). In Zahler, two insurers issued D&O policies with fiduciary liability coverage endorsements in succeeding policy periods. Shareholders of the insured company brought a class action securities lawsuit, alleging that the insured company, including its chief executive officer, made public statements and filings that misled investors about the state of the insured s financial health, specifically with respect to certain investments by the insured company U.S. Dist. LEXIS 14263, *4. This claim was made and reported to the insurer during the first policy period. A class action was subsequently filed by participants in the insured company s 401(k) plan under ERISA. This action alleged that the insured company s officers breached fiduciary duties owed to employees and other participants in the 401(k) plan under ERISA U.S. Dist. LEXIS 14263, *6 7. Similar to the ERISA complaints recently filed against financial institutions, the ERISA complaint at issue in Zahler alleged that individual defendants breached their fiduciary duties by continuing to permit the plan to invest in company stock when it was no longer a suitable or prudent investment option. Id. at *7. This

4 lawsuit was filed, and noticed to the insurer, during the second policy period. The insurer that issued the second implicated policy argued that the allegations in the ERISA action were substantially similar to the allegations in the securities class action. The second insurer argued these allegations constituted prior acts and, accordingly, were excluded from coverage under its policy. The prior acts exclusion in the second policy provided that [n]o coverage will be available for Loss in connection with Claims for Fiduciary Wrongful Acts based upon or in any way involving any fact, circumstance, situation, transaction, event or Fiduciary Wrongful Act which, before the effective date of this endorsement, was the subject of any notice given under any other management liability insurance policy, D&O liability policy, pension and welfare benefit plan fiduciary liability insurance policy or similar policy. Id. at *5. Further, the second policy included an interrelated claims provision, which stated that all Claims arising from the same Interrelated Wrongful Acts shall be deemed to constitute a single Claim and shall be deemed to have been made at the earliest of the time at which the earliest such Claim is made or deemed to have been made. Id. at *15. The court in Zahler, in interpreting the prior acts exclusion and interrelated claims provisions of the second insurer s policy, held that the ERISA claim was first made during the earlier policy period, when the shareholder plaintiffs filed the securities derivative action. The court examined the allegations set forth in the ERISA and securities complaints and found them to be consistent and, in many cases, identical. Id. at * Specifically, the court observed that the facts that the ERISA litigation arises out of, viz., the alleged misstatements regarding the financial health of [the insured s investments] are the same as those out of which the Securities Litigation arises. Id. at *6 7. The court held that the first policy provided coverage for the ERISA action, even though the ERISA claim was first asserted and tendered during the second insurer s policy period. The subprime mortgage and credit crisis has thus far produced a number of different lawsuits. See Alan Rutkin, Robert Tugander, & Katherine Maguire, Insurance Coverage Issues Arising from the Subprime Crisis, For The Defense (May 2008), p. 38. Companies, as well as their officers and directors, may be increasingly subject to derivative securities actions and tag along fiduciary liability class actions that repackage these allegations as ERISA claims. If successive policies are issued by different insurance carriers, uncertainties may arise about when the ERISA claim was first made and whether the ERISA claim was sufficiently similar to a previously filed securities action to fall within the scope of a prior acts exclusion. Who Is an Insured? The definition of an insured is a basic, yet important consideration in determining the scope of coverage afforded by fiduciary liability policies. If, for example, claims are asserted against pension plan trustees, as well as de facto fiduciaries, a critical question will be whether a party potentially liable as a fiduciary under the broad language of ERISA qualifies as an insured under the policy. Regarding the recently filed ERISA class actions brought against financial institutions and their directors and officers as de facto fiduciaries of the employee benefit plans, the applicable fiduciary liability policies may, or may not, define an insured to include any fiduciary under the broad language of ERISA. If, for example, the Who Is an Insured section of the policy defines natural persons insured to include pension plan trustees, and employees of the pension plan, the insurer may argue that the parties to the insurance contract did not intend for coverage to apply to any party that may qualify as a fiduciary under Section 1002(21)(A) of ERISA. This may be particularly relevant when determining whether a fiduciary liability policy extends coverage to ERISA claims filed against independent directors and officers of the company sponsoring the pension plan. Dishonesty and Personal Profit Exclusions As with D&O policies, fiduciary policies typically include a dishonesty exclusion, precluding coverage for claims based upon or arising from a deliberately dishonest, malicious, or fraudulent act or omission or willful violation of law. In addition, these policies generally include a personal profit exclusion for claims based upon or arising from a personal profit or advantage to which the Insured is not legally entitled. Depending on the specific policy language, these exclusions apply only if the prohibited conduct is demonstrated in fact or by way of a final adjudication. Recent ERISA class actions have alleged that the defendants knowingly breached their fiduciary duties under ERISA. Specifically, these complaints alleged that pension plan trustees and individual officers and directors willfully failed to disclose important facts to plan participants regarding the financial well-being of the company. It has been alleged that these willful failures violated ERISA. For example, in Stanislaus, et al. v. UBS, et al., Index No.: (S.D.N.Y.), the plaintiff class alleged that individual defendants knowingly failed to disclose to plan participants the heightened degree of risk associated with investment in UBS stock, thereby breaching their duty of loyalty to plan participants under ERISA. As alleged in this complaint, ERISA requires fiduciaries to speak truthfully to participants, not to mislead them regarding the plan or plan assets, and to disclose information that participants need, in order to exercise their rights and interest under the plan. See 181. Similarly, in Rinehart, et al. v. Lehman Brothers Holdings, Inc., et al., Index No.: (S.D.N.Y.), the complaint alleges that individual defendants knew that inaccurate and incomplete information had been provided to participants, and these defendants failed to remedy this situation by ensuring correct information was transmitted to plan participants. See 121. Personal conduct exclusions may be implicated in these and similar actions that may be filed in the future. However, if the applicable fiduciary liability policy provides that the dishonesty or personal profit exclusions apply only after adjudication of dishonesty, fraud, illegal profits, or willful violation of law, then these exclusions will not apply based simply on the allegations contained in the complaint. Insurers may be responsible for payment of defense costs, to the extent provided for under the applicable policy. Further, if actions settle before the con- For The Defense n February 2009 n 37

5 duct contemplated by these exclusions is demonstrated in fact or by a final adjudication, then the insurer may be obligated to contribute to the ultimate settlement of the claims. Insurer s Obligation to Pay Defense Costs Fiduciary liability policies, as with D&O policies, may provide that the insurer is not obliged to defend the insured. However, the policy should be examined to determine whether the insurer is obliged to advance defense costs, or reimburse the insured for these expenses. In addition, the policy should be examined to determine whether the insurer s payment of defense costs erodes the policy s limits of liability. Some policies provide for reimbursement of defense costs, in addition to the limit, but capped at the ratio that the policy limit bears to the ultimate judgment. For example, if there is a judgment for $2 million and the policy limit is $1 million, the insurer would be required pay 50 percent of defense costs in excess of its policy limit. See Clark, supra, p. 2. Some policies also include a tyingof-limits provision, applicable to policyholders that procure D&O coverage and fiduciary liability coverage from the same carrier. Under this provision, an insurer is liable only for the higher of the two limits the D&O policy limit or fiduciary liability policy limit but not both if circumstances leading to the loss are the same under both policies. See Sammer, supra. Conclusion As with the corporate scandals and bankruptcies of the early part of this decade, declining stock values are again resulting in ERISA class action lawsuits filed against pension plan trustees and directors and officers. Several defendants in these claims are also named defendants in federal securities actions. Under fiduciary liability policies, the definition of an insured, the prior acts, dishonesty, and personal profit exclusions, as well as policy provisions concerning reimbursement of defense costs, should be carefully examined to determine the scope and extent of coverage for ERISA claims. 38 n For The Defense n February 2009