A federal judge sitting in New York but applying Maryland law recently held that a Directors and Officers (D&O) insurer is not required to provide insurance coverage because the policyholder breached the policy’s consent-to-settle provision when it settled a securities class action without obtaining the carrier’s prior approval. Federal Ins. Co. v. SafeNet, Inc., 2011 WL 4005353 (S.D.N.Y. Sept. 9, 2011). The opinion is noteworthy because the court found that the insurer did not waive its right to require consent to the settlement agreement when it notified the policyholder that it had grounds for denying coverage and was contemplating rescinding the policy.

Background

The insured, SafeNet, Inc., provides information-security technology to public and private customers. In February 2006, the company disclosed material errors in its financial statements. In May 2006, SafeNet received a subpoena from the U.S. Attorney’s office relating to its granting of stock options, and the SEC began a formal inquiry into the company’s stock option grants as well as its accounting policies and practices. SafeNet later concluded that it had used incorrect accounting measurement dates for certain stock options and would need to restate its financial statements. The SEC followed with an enforcement action and a criminal investigation, and shareholders filed a securities class action. SafeNet’s former Chief Financial Officer, Carole Argo, ultimately pled guilty to securities fraud, and SafeNet settled the securities class action lawsuit for $25 million.

The Court’s Ruling

SafeNet had two successive (2005-06 and 2006-07) claims-made D&O excess policies with Federal Insurance Company (Federal). Federal advised SafeNet in summer 2008 that, due to Argo’s guilty plea, “a declination in coverage is in order in certain respects . . . and that rescission of this policy may be appropriate,” and proposed that they enter into a tolling agreement. SafeNet settled the class action in late 2010 for $25 million, without notifying Federal of the settlement negotiations or seeking Federal’s consent prior to settling the class action. Federal filed a declaratory judgment action against SafeNet, Argo and others, seeking a declaration of coverage obligations. On summary judgment, the Southern District ruled that Federal was not required to provide coverage.

As an initial matter, the court held that only the 2005-06 policy was implicated, because all claims related back to that policy. According to the court, the financial irregularities SafeNet disclosed to the carrier in February 2006, and the stock options backdating, “were part of an interrelated course of conduct.” Because of that interrelationship and the policy’s “broad relation-back language,” the court said, the subsequent matters related back to the original notification.

The Southern District also held that the policy’s fraudulent conduct exclusion applied to preclude coverage for any loss incurred by Argo, who had pleaded guilty to fraudulent acts, allocated to willful and deliberate conduct, and had an adverse judgment entered against her. Although Argo’s knowledge was imputed to SafeNet, the court held that the fraudulent conduct exclusion did not apply to SafeNet because no adverse judgment had been entered against it, as required under the policy terms.

Nevertheless, the court held that the company was not entitled to coverage because it did not secure Federal’s consent prior to entering into the settlement. According to the court, Federal did not waive its right to approve the settlement when it said that it was investigating its obligations under the policies, that it believed partial rescission was appropriate, that coverage would remain for certain insureds who lacked knowledge of the inaccurate information in the insurance application, and that it would seek judicial input concerning its obligations under the policy.

Federal also was entitled to rescind the policy as to Argo because she knowingly and intentionally caused SafeNet to make inaccurate statements in its public filings that made their way into the insurance application. The court did not require Federal to show that the inaccurate statements were material, or that Argo knew the statements would be incorporated into the insurance application. Federal also was entitled to rescind the policy as to SafeNet because Argo’s knowledge, as CFO, was imputed to the company.

Summary

The SafeNet decision reaffirms that consent-to-settlement provisions are enforceable, and that settlements will not be binding upon insurers unless the insurers have given their consent. In the absence of a blanket denial of coverage, an insured will not be excused from complying with the terms of a consent-to-settlement provision. Moreover, factual misstatement in a company’s financial statements, which are incorporated in the insurance application, may be sufficient to render a policy void as to the person who made the misrepresentations, and to the company itself, if that knowledge is specifically imputed to the company under the policy terms.