The Public Policy Defense: A Potential "Sleeping Giant" in D&O Coverages Disputes
February, 2002
At a time when many corporations are facing financial difficulties or third-party claims seeking financial restitution for corporate wrongdoing, this article discusses two recent decisions by the U.S. Court of Appeals for the Seventh Circuit sustaining a carrier’s denial of coverage under a D&O insurance policy. Both decisions reflect the view that the perceived availability of insurance coverage may encourage corporate wrongdoing and that a finding that a D&O policy provides coverage for certain wrongful conduct may be inconsistent with public policy.
Mortenson v. National Union
In May, 2001, the Seventh Circuit issued its decision in Mortenson v. National Union Fire Insurance Company of Pittsburgh, PA., 249 F.3d 667 (7th Cir. 2001), in which Clausen Miller secured, and successfully defended on appeal, summary judgment in favor of the defendant carrier. (We originally reported on Mortenson in Volume 2 of the 2001 CM Report.) The plaintiff in Mortenson was the former president of a manufacturing firm: while he was president, the firm failed to pay payroll taxes but continued to pay other creditors. After the company declared bankruptcy, the IRS assessed a penalty against the plaintiff pursuant to 26 U.S.C. Sec. 6672(a), which makes any person responsible for collecting, accounting for and paying payroll taxes, and who “wilfully” fails to do so, liable for a “penalty” equal to the amount of the unpaid taxes.
In the declaratory action, Mortenson sought reimbursement from the company’s D&O carrier for the amount he paid to settle the IRS’s claim. In response, National Union argued that coverage was properly denied based on an exclusion in its policy for “losses” that consist of “fines or penalties imposed by law.” Alternatively, it was argued that insurance coverage for penalties imposed under Sec. 6672(a) would be contrary to public policy.
Judge Richard Posner, writing for the Court of Appeals, concluded that Sec. 6672(a) imposes civil penalties for wrongful conduct and that civil fines fall within the “fines and penalties” provision of the policy. Posner went on to note that the availability of insurance coverage in such cases would encourage wrongful conduct, and that a strong argument can be made that public policy bars coverage for such conduct:
Consider the likely effects of insuring against the section 6672(a) penalty.... It is to prevent firms from yielding to the temptation to put the IRS at the end of the creditor queue that Congress has imposed liability for nonpayment of payroll taxes on the responsible officers of the firm. For those persons to be insured against this liability will tempt them to do just what [the plaintiff’s firm] did here and what the penalty provision of section 6672(a) is designed to prevent....It is strongly arguable, indeed, that insurance against the section 6672(a) penalty, by encouraging the nonpayment of payroll taxes, is against public policy, so falling ... possibly under the rule in Illinois as elsewhere that forbids certain types of insurance as being against public policy because of the acute moral hazard that the insurance creates.
Level 3 Communications, Inc. v. Federal Ins. Co.
The coverage claim in Level 3 Communications, Inc. v. Federal Ins. Co., 272 F. 3d 908 (7th Cir. 2001), arose out of a prior lawsuit against Level 3’s predecessor corporation. The plaintiffs in the underlying suit were minority shareholders in the predecessor corporation and alleged that they were induced to sell their shares to Level 3 based on Level 3’s fraudulent representations, and sought monetary relief. The fraud suit was eventually settled for $11.8 million, and thereafter Level 3 looked to its D&O carrier for reimbursement.
In Level 3’s subsequent declaratory action, the trial court held that the settlement of the fraud suit was a “loss” within the meaning of the D&O policy, and entered judgment for Level 3. On appeal, the insurer argued that the settlement was not a “loss” as defined by its policy because the relief sought in the underlying fraud suit was restitutionary in nature. The carrier further argued that Level 3’s attempt to obtain coverage for the fraud settlement was no different than if Level 3 had been forced to return stolen cash, and then asked its insurer to pick up the tab. Citing Mortenson, the carrier argued that it would be against public policy to insure a thief against the cost of disgorging the proceeds of a theft.
Reversing the trial court, Judge Posner, again writing for the Court, affirmed as “clearly right,” the carrier’s contention that a “loss” within the meaning of an insurance policy does not include the restoration of an “ill-gotten gain.” Though that finding made it unnecessary to address the carrier’s “public policy” argument, Posner proceeded to note that an insurance policy should not be construed in a manner that renders it unenforceable and that the insured’s arguments in support of coverage would not change the fact that a finding of coverage would allow the insured to retain an ill-gotten gain. Posner noted that the meaning of the term “loss” does not depend on how the underlying claim, judgment or settlement was phrased because however worded, the underlying claims sought to divest Level 3 of the value of property obtained through fraud, and “an insured incurs no loss within the meaning of the insurance contract by being compelled to return property that it had stolen, even if a more polite word than ‘stolen’ had been used to characterize the claim against the insured.”
The same reasoning led Posner to reject Level 3’s argument that it was entitled to coverage regardless of the nature of the underlying claim against it, so long as the claim was settled before entry of judgment. Posner stated:
That can’t be right. ... It would mean ...that if Level 3, seeing the handwriting on the wall, had agreed to pay the plaintiffs in the fraud suit all they were asking for (a very large amount - almost $70 million), which they surely would not have done had there been no evidence of fraud . . .Federal would still be obligated to reimburse Level 3 for that amount. And that would enable Level 3 to retain the profit it had made from a fraud.
A recent profile of Posner notes that he is a champion of pragmatism, and is of the opinion that jurists should evaluate the consequences of their decisions and “what kind of incentives their ruling were putting in place,” rather than deciding rights and duties in the abstract. (See “The Bench Burner,” Larissa MacFarquhar, The New Yorker, December 10, 2001, p. 78). Mortenson and Level 3 are examples of this approach applied to claims for D&O coverage. The same article notes that Posner is cited in scholarly journals more often than any other jurist: thus, other judges are likely to be familiar with his views and may adopt those views in future cases.
Practice Tip:
The philosophy expressed in Mortenson and Level 3 may provide a defense to claims for coverage under D&O policies for statutory penalties or settlements of claims alleging fraud or similar misconduct, especially if a policy exclusion does not apply thereto. Although the public policy analysis in Mortenson and Level 3 constitutes dicta, many judges may give serious consideration to an argument that is based on views expressed by a jurist as influential as Posner. These two decisions underscore the importance of hiring counsel familiar with the philosophies of judges in the jurisdiction where a coverage dispute will be resolved.
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