The United States Bankruptcy Court for the Southern District of New York granted preliminary injunctions ordering a directors and officers liability insurer to advance defense costs, despite the fact that the insurer had denied coverage, and without adjudicating the coverage defense. Axis Reinsurance Co. v. Bennett et al., Adv. No. 07-01712 (S.D.N.Y. Bankr. Aug. 31, 2007); Grant v. Axis Reinsurance Co., Adv. No. 07-2005 (S.D.N.Y. Bankr. Sep. 11, 2007). The bankruptcy court applied New York law and relied heavily on the case In re WorldCom, Inc. Securities Litigation, 354 F. Supp. 2d 455 (S.D.N.Y. 2005).
The insurer issued an excess directors and officers liability insurance policy to Refco, Inc. The policy included a warranty letter stating that "[n]o person(s) or entity(ies) proposed for this insurance is cognizant of any fact, circumstance, situation, act, error or omission which he/she/it has reason to suppose might afford grounds for any Claim, as such term is defined within the Policy, such as would fall within the scope of the proposed insurance." The policy also contained a prior-knowledge exclusion that provided that "[i]n consideration of the premium charged, it is agreed that this Policy does not respond to Claims based upon, arising out of, directly or indirectly resulting from, in consequence of, or in any way involving any fact, circumstance, situation, transaction or event, which as of the inception date of the Policy Period, any Insured had knowledge and had reason to suppose might give rise to a Claim that would fall within the scope of the insurance afforded by this Policy."
The policy incepted on the date of Refco's initial public offering. Two months after the IPO, Refco announced that its financial statements had failed to disclose the existence of a large related-party receivable and therefore were unreliable. Specifically, the company disclosed that an entity controlled by Refco's then-CEO Phillip Bennett owed Refco approximately $430 million, and that this amount may have represented the Bennett-controlled entity's assumption of uncollectible debt owed to Refco. The company entered bankruptcy shortly thereafter. Numerous lawsuits followed, including securities fraud litigation against certain former directors and officers. In addition, Refco's former CEO, CFO and President were indicted on federal securities fraud and other charges.
Neither the primary policy nor the underlying excess policy contained warranties or prior-knowledge exclusions. After the underlying insurers exhausted their limits through payment of defense costs, the excess insurer filed an adversary proceeding in the Refco bankruptcy case, seeking a declaration that it owed no coverage to the directors and officers in light of the warranty letter and prior-knowledge exclusion. Certain former directors moved to dismiss the complaint, contending that the facts needed to adjudicate the coverage action overlapped with facts in the underlying actions and should be decided in the underlying actions. In addition, the indicted defendants moved to dismiss or stay the complaint in light of their pending criminal trial. Finally, certain officers filed a counterclaim for injunctive relief seeking advancement of defense costs and filed a motion for a preliminary injunction ordering the insurer to advance defense costs. Specifically, the officers pointed to a provision in the primary policy, to which the excess insurer's policy followed form, which provided that "[t]he Insurer will pay covered Defense Costs on an as-incurred basis. If it is finally determined that any Defense Costs paid by the Insurer are not covered under this Policy, the Insureds agree to repay such non-covered Defense Costs to the Insurer." The officers contended that under this provision, the insurer was not relieved from advancing defense costs merely because it had "unilaterally" denied coverage. Rather, the officers contended that the provision mandated that the insurer advance defense costs until it had obtained a court determination that the policy afforded no coverage.
The court granted the motions to dismiss filed by the director defendants and the indicted defendants, holding that the declaratory judgments the insurer sought must await the development of underlying facts in the underlying actions. The court held that the officers' counterclaim could proceed, however, because the question of contemporaneous advancement involved only contractual interpretation of the advancement provision and did not depend on any underlying facts. The indicted defendants subsequently filed an affirmative claim seeking advancement as well.
The court held that the officers and indicted defendants were entitled to a preliminary injunction ordering advancement of defense costs. The court held that the insureds had shown a likelihood of success on the merits of their interpretation of the advancement provision. The insurer had argued that under the advancement provision it had an obligation to advance only "covered Defense Costs" and that the officers had not made any showing that their defense costs were, in fact, covered in light of the warranty letter and prior-knowledge exclusion. The insurer also argued that the officers had failed to give any meaning to the word "covered" in the phrase "covered Defense Costs."
The court rejected these arguments, reasoning that the second sentence of the advancement provision—"If it is finally determined that any Defense Costs paid by the Insurer are not covered under this Policy, the Insureds agree to repay such non-covered Defense Costs to the Insurer"—would be rendered superfluous under the insurer's interpretation. The court did not find persuasive the insurer's argument that the clause requiring repayment was not superfluous but would be triggered when the insurer had reserved rights as to exclusions requiring a "final adjudication" of fraud or personal profit. In addition, the court held that the word "covered" in the phrase "covered Defense Costs" was likely only meant to reference coverage under the insuring agreement, ignoring the argument that such a reading would render policy exclusions nugatory. Citing In re WorldCom, Inc., Securities Litigation, 354 F. Supp. 2d 455 (S.D.N.Y. 2005), the court opined that directors and officers policies are intended to provide advancement of defense costs until the insurer obtains a judicial determination of noncoverage. The court was unpersuaded that the holding in WorldCom was distinguishable because that case concerned insurers' attempts to rescind policies that they otherwise conceded afforded coverage. The court also held that the officers and indicted defendants had shown irreparable harm. The insurer had argued that the insureds had made no showing that they would be unable to continue their defense of the underlying actions absent insurance proceeds. However, the court did not require such a showing. Instead, the court relied again on WorldCom, in which the district court held that where underlying litigation is "massive," directors or officers seeking advancement of defense costs need not make a showing as to their personal wealth in order to obtain advancement. The bankruptcy court declined to require the insureds to make any showing that they would be able to repay the insurer in the event the insurer's coverage denial were held to be correct. Indeed, the court held that any harm to the insurer was not significant because the insurer's loss was capped by the amount of the policy, and it specifically had assumed the risk that it might have to advance amounts it could not recoup. Finally, the court denied the insurer's request that the insureds post a bond. The preliminary injunction is in effect pending the parties' summary judgment briefs regarding interpretation of the advancement provision.