In the recent spate of backdating lawsuits, and in the current wave of financial institution litigation, Directors & Officers (D&O) liability carriers have almost uniformly taken the position that the costs of a company’s Special Investigation (or Litigation) Committee (SC) are not covered “Loss.” Two cases in 2009 – the first to address this issue – concluded otherwise.

A company faced with allegations of wrongdoing by its directors or officers may choose to form a Special Committee of independent directors to investigate the allegations and make a determination of their merits. Many cases involve an SC that is formed in the wake of allegations of possible wrongdoing that may not themselves qualify as a “Claim” under the policy. In most cases, however, a covered Claim in the form of an SEC or DOJ investigation and direct or derivative shareholder actions follow within days or weeks.

D&O insurers have taken the position that the often substantial fees and costs incurred by the SC and its attorneys are a cost of doing business; i.e., the directors are merely carrying out a duty to the company to conduct an investigation. The company, on the other hand, argues that the SC’s work will in fact form the core of the company’s response to the SEC, DOJ, and shareholder plaintiffs claims. Its work will be used, and not duplicated, by defense counsel. As such, they are reasonable and necessary to the defense of the various Claims.

A recent case by a federal court in California, Hansen Natural Corporation v. St. Paul Mercury Ins. Co., No. CV-08-5067-VBF (C.D. Cal. March 26, 2009), sided with the policyholder. In that case, the court denied St. Paul’s motion for summary judgment, in which the insurer argued that the Special Committee costs were not covered defense costs under its D&O policy.

Hansen presented the more common scenario, in which the SEC initiated an investigation into backdating practices. The company thereafter formed an SC, and shareholder suits followed and proceeded in parallel. The court held that the fact that the SC was formed before the lawsuits were filed was not determinative. The court pointed to facts showing that the SC’s work formed the basis for discussions with the civil plaintiffs and ultimately led to a favorable settlement of the litigation.

A new case has reached the same conclusion as Hansen. In MBIA v. Federal Ins. Co., No. 08 Civ. 4313 (RMB) (S.D.N.Y. Dec. 30, 2009), MBIA sought coverage under D&O policies for the costs of responding to investigations and claims by the New York Attorney General, the SEC, and to two derivative suits. An SC was formed in the wake of the derivative suits. Federal denied coverage for the SC, arguing somewhat unusually that the SC was an independent entity that was not an insured under the policy. The district court rejected its arguments and held that the SC costs were recoverable.

A case this firm is handling falls squarely within this precedent. The first allegations of wrongdoing came with the filing of a derivative suit against certain company directors. There was no pre-litigation investigation or allegations. The company formed the SC to protect its interests solely in response to the derivative complaint. The SC investigated the merits of the allegations and determined that they were without merit. As a result, the company successfully moved to dismiss the complaint. All of the work by the SC, therefore, constituted reasonable and necessary fees and costs resulting solely from the investigation and defense of a Claim against the insured.

Companies contemplating the creation of an SC should therefore not accept insurer objections to paying for the SC’s costs.