The Second Circuit has declared that a bond insurer’s D&O program was obligated to pay costs incurred by an independent consultant who was hired during the course of settlement negotiations, despite the carrier’s claimed lack of an effective association in the settlement.  MBIA, Inc. v. Federal Insurance Company and ACE American Insurance Company, No. 10-355 (2d Cir. July 1, 2011).

The insured was a municipal bond insurer.  As part of a formal investigation in violations of federal securities laws, the SEC and the New York Attorney General began to subpoena documents from the insured in November 2004.  Ultimately, three transactions attracted deep regulatory scrutiny, all of which were designed to permit the insured to avoid recognizing large, one-time insurance losses.

The insured tendered the claims in May 2005.  The carriers, in turn, did not view the subpoenas as sufficient to trigger coverage, but accepted them as notice of a potential claim under the policies.  The insured proceeded to retain defense counsel to respond to the regulatory inquiries.

In August 2005, the regulators advised that they would pursue claims for violations of the securities laws against the insured.  The insured, in September, sought permission from the carriers to open settlement negotiations.  In turn, the carriers stated that they did not believe any settlement would fall within the scope of coverage, but allowed the insured to proceed, saying they would not raise the lack of their written consent to the settlement as a coverage defense.

The broad outline of a settlement was reached in October 2005, save for one loose end: the regulators indicated that they had not completed their investigation into all aspects of two of the three subject transactions.  To allow the settlement to proceed, the insured and the regulators agreed that the insured would retain an independent consultant to review the transactions and report on a proposed remedy if he uncovered further misconduct.  The insured first informed the carriers of this development in September 2006.

The proposal proved acceptable to the regulators.  In January 2007, they accepted a $75 million penalty payment from the insured for one transaction, and the independent consultant’s investigation to resolve the remaining two.  The investigations concluded in 2007.

In subsequent litigation to compel payment from the carriers for the costs incurred in connection with the investigation and the settlement, the district court ruled generally in favor of the insured.  It allowed claims for costs incurred in complying with the regulators’ investigation, and costs incurred by the special litigation committee to respond to subsequent shareholder litigation.  The district court, however, agreed with the carriers that the independent consultant’s costs were outside the scope of coverage because the creation of the consultant’s position in the course of settlement discussions breached the carriers’ rights to associate and consent.

The Second Circuit reversed, noting that the purpose of a “right to associate” clause is to provide the insurer with the option to intervene in the defense or settlement of a claim.  The right to associate, however, is only useful if the carrier can use its experience for the benefit of the insured throughout the process, and not just at the end stages.  The court held that, here, the insured had given the carriers notice of the claim and efforts to settle it in September 2005, which was sufficient.

The court characterized the addition of the consultant as part of the “natural course of settlement discussions,” in which the carriers had declined to participate.  The court also noted that the insured had first notified the carriers of the consultant’s addition to the settlement framework in September 2006, four months before the January 2007 consummation of the agreement.  Accordingly, the court held that the right to associate had not been denied, and further held that the insured “was entitled in this case to presume that the insurers would not raise the lack of written consent as a defense to coverage with respect to the” consultant’s costs.

’The Second Circuit’s decision reflects a continued desire on the part of the court to see insurers provide a defense for their insureds against all aspects of a regulatory investigation.  While the $75 million settlement at issue in this case may not have been covered, the court concluded that costs incurred in the defense of the investigation and in reaching the settlement were.

For a complete copy of the decision, please click here.