D&O insurers win declaratory judgment via insured capacity exclusion

A recent decision by a New York trial court highlights the impact corporate structure has on the scope and availability of directors and officers (D&O) insurance. The Commercial Division of New York’s Supreme Court applied an insured capacity exclusion to preclude D&O coverage for American Realty Capital Properties and related entities (AR Capital) and their directors and officers. The opinion, issued on February 2, 2021, highlights the importance of confirming that alleged wrongful conduct was undertaken in an insured capacity for D&O coverage.

Background: Underlying litigation

AR Capital was a publicly traded real estate investment trust (REIT). The individual defendants were members of AR Capital. AR Capital sponsored and managed a publicly traded REIT, now known as VEREIT. AR Capital, via a wholly owned subsidiary (ARC Properties Advisors, LLC) provided management and advisory services related to VEREIT’s investments and operations until 2014. Following an audit conducted in 2014, VEREIT released several restatements of the company’s prior financial statements in 2014 and 2015. Unsurprisingly, a securities action, a derivative suit, and an SEC investigation ensued.

The consolidated complaint in the securities action alleged that the individual defendants made false and misleading statements in violation of several provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934. Separately, VEREIT shareholders filed a derivative lawsuit against directors Schorsch, Kahane and Weil for breaching their duties owed to VEREIT as members of VEREIT’s board and the SEC initiated an enforcement action against AR Capital and Schorsch.

On September 20, 2019, the parties filed a stipulation of settlement, where the defendants agreed to pay $1.025 billion “in full and final disposition of the litigation”. AR Capital and advisors agreed to contribute $225 million towards the settlement. On October 2, 2019, the parties filed a stipulation of settlement in the Derivative Action. Pursuant to the stipulation of settlement, the AR Capital parties would contribute the $225 million to the class action settlement as above.  A consent judgment was reached in the SEC enforcement action whereby AR Capital and Schorsch were each required to disgorge certain securities and specified cash amounts.

The Policy and Coverage Dispute

AR Capital maintained a $50 million tower of D&O insurance. VEREIT also maintained a separate $80 million D&O insurance program.

The AR Capital policy provided coverage for Loss arising from a Wrongful Act. Wrongful Act was defined as “any actual or alleged act, omission, misstatement, misleading statement, neglect, or breach of duty by and Insured Person while acting in his capacity as … an Insured Person of the Company and “any matter asserted against an Insured Person solely by reason of his or her status as a director or officer of the Company.”

An Insured Capacity exclusion provided that the insurer was not liable for Loss in connection with any Claim made against an Insured Person “based upon, arising out of, directly or indirectly resulting from, in consequence of, or in any way involving an Insured Person action in their capacity as a [sic] Insured Person of any other entity other than the Company [i.e., AR Capital].”

An insurance coverage dispute arose in connection with AR Capital’s D&O insurance tower. AR Capital, related entities and the four individuals (Schorsch, Weil, Kahane, and Budko) sought to obtain coverage for the four individuals’ portion of the lawsuit settlements and the SEC consent judgment. The Insurers denied coverage for and/or reserved their rights to deny coverage under the excess policies on the basis that:

  1. There was no Securities Claim for a Company Wrongful Act against AR Capital;
  2. There was no Claim for a Wrongful Act against any Insured Person in his or her insured capacity; and/or
  3. Exclusion I of the primary policy barred coverage for VEREIT Securities Matters

The Insurers argued that the individual defendants are not entitled to coverage for the settlements in the Securities Class Action and Derivative Action because they faced liability solely for acts undertaken in their uninsured capacities as directors and officers of VEREIT. In addition, the Insurers contended that the AR Capital parties did not pay any amount to settle the Derivative Action and thus did not suffer any Loss. The AR Capital parties countered that the Securities Class Action and the Derivative Action alleged that the individual defendants, as directors and officers of AR Capital and its subsidiaries, had enriched themselves at the expense of VEREIT by causing VEREIT to make improper and inflated payments to AR Capital and its subsidiaries and the complaints contain numerous allegations asserting wrongful conduct in an AR Capital capacity.

The insurers initiated an action seeking a declaratory judgment for lack of coverage and the parties eventually filed cross-motions for summary judgment.

Opinion

Applying New York law, Justice Joel M. Cohen granted the insurers’ motion for summary judgment and denied the AR Capital parties’ cross-motions in his opinion.  

The settlements of the securities and derivative actions, Judge Cohen said, “did not result from Claims for their Wrongful Acts in an AR Capital capacity.”  Rather, the securities law violations were made against the directors in their capacities as director and officers of VEREIT, and, in the derivative actions, the director defendants “were sued for breaching their fiduciary duties to VEREIT as members of VEREIT’s board of directors, not to AR Capital.”  Judge Cohen confirmed that “the AR parties have failed to demonstrate that their potential liability was for Wrongful Acts in an AR Capital capacity.”

Further, Judge Cohen noted that the Capacity Exclusion was “clear and unambiguous”. The exclusion was found to apply because the allegations in the underlying actions “in any way involve” the individual defendants “acting in their uninsured capacities for VEREIT”.

Finally, Judge Cohen confirmed that disgorgement amounts paid as a result of the SEC investigation were uninsurable as a matter of law.

What this means?

Directors and officers often act in multiple capacities, both within a company and in other entities, often serving simultaneously as board members or directors of several entities. As corporate relations and structures become more convoluted, the consideration of “insured capacity” triggering coverage, or the correct source of coverage, it not always straightforward. This judgment highlights the importance of understanding in what capacity directors and officers are acting, or are alleged to have acted, in order to ensure the appropriate application of their respective company policies.

The Insured Capacity exclusion was arguably broad (“in any way involve”), leaving a potentially wide door for insurers to deny claims on the basis of directors acting in dual capacities.  Judge Cohen caveated this with a causation test considering whether the “claims in the underlying actions ‘in any way involve’ the individual defendants in their uninsured capacities for VEREIT”.

In evaluating coverage, insurers may be able rely on similarly worded exclusions when insureds are acting in multiple roles. In doing so, D&O insurers may be best suited to consider and understand the corporate structure of their insureds and other roles individual directors and officers serve in to ensure coverage operates as intended.

Read other items in Professions and Financial Lines Brief - March 2021