In the underlying action, the SEC commenced an investigation into an advertising company (the “Company”) arising from possible misappropriation of funds. As a result of the potential impact to the Company’s financials, the Company notified the SEC of a delay in filing its annual report while it conducted an internal investigation. Shortly notice, the SEC commenced its own investigation and further sought a “tolling agreement” from the Company with respect to potential claims being made against the Insured.

The Company promptly notified its D&O carrier of the tolling agreement and sought coverage for defense costs incurred for the time-period after the tolling agreement was executed. The Company argued that the tolling agreement met the Policy’s definition of Claim and, therefore, any defense costs and, possibly, settlement payments made in the future should be covered Loss. Implied within the Company’s request for coverage was the presumption that the SEC was investigating potential violations of securities laws which, therefore, brings the matter within the Policy’s Side C (entity coverage) for Securities Claims.

The carrier denied coverage and took an aggressive position that despite the Policy definition of Claim—which included a tolling agreement as a proper trigger for coverage—the analysis did not stop there. The coverage determination needed to go deeper and account for the different requirements for Side C entity coverage under the Securities Claim definition. The carrier argued that the SEC matter did not fall within the definition of Securities Claim because it was merely an “investigation” and, as such, was carved out from the applicable definition. Further, the carrier noted the investigation did not allege any specific violations of federal or state securities laws or seek redress of any kind.

The Company filed a coverage lawsuit against the carrier in Delaware Superior Court. In a surprising result, the court sided with the carrier and found that “not only are there no allegations of wrongdoing "in the tolling agreement" (which could trigger the definition of Securities Claim), but also the SEC was not seeking any particular relief for a Wrongful Act. Thus, the carrier was not responsible for reimbursing the Company’s defense costs. Ultimately, the Company settled with the SEC for $26 million following allegations of securities laws violations and yet the carrier avoided their financial obligation to cover Loss for such securities violations.

A federal court, applying California law, held that a dilution claim carve-back to a D&O policy’s Insured versus Insured exclusion (“IvI”) restored coverage for a director’s claim. 

In the underlying action, the founder of the insured company (the “Company”), his spouse, and his family trust alleged that one of the Company’s directors breached his fiduciary duties to the Company and its shareholders following his actions related to a merger and subsequent sale of the Company. The sale was with another entity in which the director was also an investor and a director. The complaint alleged that the director exploited his position to his own benefit and to the detriment of the founder’s family, which resulted in the unfair dilution of the shares they received in the merger.

The director sought coverage for the underlying lawsuit from the Company’s D&O carrier, which denied coverage citing the policy’s IvI exclusion. The exclusion provided, in part:

Insurer shall not be liable for Loss under this Coverage Section on account of any Claim . . . brought or maintained by, on behalf of, in the right of, or at the direction of any Insured in any capacity, any Outside Entity or any person or entity that is an owner of or joint venture participant in any Subsidiary in any respect and whether or not collusive[.]

The carrier argued that the founder, as a former director and officer of the Company, was an Insured under the policy, as was his spouse, and the underlying action was brought in an Insured capacity, thus barring coverage. 

The exclusion also included a carve-back for dilution claims, which provided that coverage was restored for a claim that might otherwise be excluded if such claim: 

is brought or maintained by any former Director or Officer of the Company solely in their capacity as a securities holder of the Company and where such Claim is solely based upon and arising out of any actual or alleged unfair dilution of such securities holder’s securities interest, but only if such Claim is first made within two (2) years after the date such Director or Officer ceased to be a Director or Officer of the Company and such Claim is made in connection with the sale of a majority of the assets of the Company, the merger of the Company with or into another entity, or the initial public offering of the securities of the Company.

The carrier argued the carve-back did not apply because the allegations also implicated the founder’s capacity as a shareholder and, later, employee of the surviving entity post-merger. Therefore, the action was not brought solely in the founder’s capacity as a shareholder of the insured entity.

Ultimately, the court held that the alleged scheme persisted beyond the closing of the initial merger, thereby incidentally implicating the founder’s newfound status as an equity holder in the new company, could not negate the reality that the underlying suit was about the founder and his family retaining less money from their shares than the shares were otherwise worth absent the director’s alleged wrongdoing.