Coverage For SEC Investigations

April 10, 2002

by Mary E. McCutcheon

A company defending a securities class action often must deal with a formal investigation by the SEC as well. While Directors & Officers Liability insurers generally pay for the costs of defending the class action, they often resist paying fees relating to the SEC investigations.

As always, review the policy language. Some D&O polices expressly extend coverage to the costs of responding to D&O investigations. Even a policy which is silent on the issue, however, may provide coverage.

The insurers often will contend that an investigation by the SEC, even one conducted pursuant to a formal notice by the Commissioner, does not qualify as a "Claim" under the policy. A "Claim" is generally defined to include "any judicial or administrative proceeding initiated against [the directors, officers, or the company] in which they may be subjected to a binding adjudication of liability for damages or other relief…" With the advent of entity coverage, "Claim" is also defined to include "any judicial or administrative proceeding initiated against … any of the Directors or Officers or the Company with respect to a Securities Action …" "Securities Action" is defined as "… any Claim based upon, arising out of, or in any way involving the Securities Act of 1933, the Securities Exchange Act of 1934, rules or regulations of the SEC …"

Note that a "Claim" includes the "initiation" of any administrative proceeding. A SEC proceeding commences with, i.e., is "initiated by," an investigation. With a formal order of investigation, the SEC has the full panoply of legal powers at its disposal, including the powers to issue subpoenas and take sworn testimony. It follows that the legal services performed in the course of the investigation are those typically associated with an "administrative" or "judicial" proceeding. And it certainly cannot be denied that an SEC investigation "involves" the "rules or regulations of the SEC."

Moreover, the investigation is the first stage of a proceeding which "may" result in a binding adjudication of liability. The purpose of the investigation is to determine whether the company or individual directors or officers have violated federal securities laws. Based on the investigation, the SEC decides whether to issue a "Wells" notice, which provides the target of the investigation with an opportunity to respond to the SEC's charges. After the response is considered by the SEC, the SEC decides whether to file a formal "Complaint" in an administrative or court proceeding. So, once an investigation has begun, the insured is involved in, and must incur legal costs for, a proceeding which may well result in a "binding adjudication of liability."

In Polychron v. Crum & Forster Ins. Co. (8th Cir. 1990) 916 F.2d 461, the Court of Appeal recognized that a grand jury investigation arguably constituted a "Claim" under the policy, relying in part on the fact that the grand jury had subpoena power:

[T]he grand jury's investigation and the questioning by the Assistant United States Attorney amounted, as a practical matter, to an allegation of wrongdoing against Mr. Polychron, for which he prudently hired an attorney. The [insurance company] defendants' characterization of the grand-jury investigation as mere requests for information and an explanation underestimates the seriousness of such a probe. As later events proved, the plaintiff was the target of the investigation. Id. at 463.

There are also practical reasons why these fees should be covered. In many cases, the Complaint is filed simultaneously with a consent decree which has been negotiated between the SEC and the target. Accordingly, if the insurer need not pay defense costs until the "Complaint" is filed, there will be virtually no defense costs to pay, as a vast amount of work that goes into the determination of whether there is liability, including essentially all the SEC's discovery, is performed at the "investigation" stage of the case.

Moreover, investigation expenses are usually incurred at the same time the insured is defending a securities class action. D&O insurance provides coverage for a "Loss," which often is defined to include "costs, charges and expenses incurred by [the insureds] in connection with any Claim." In many instances the efforts necessary to defend against the class action are so intertwined with the efforts necessary to compile documents and interview witnesses in the course of the SEC investigation that, as a practical matter, both efforts are part of the same defense. Although there is little case law directly on this subject, Pepsico, Inc., v. Continental Casualty Co. (S.D.N.Y. 1986) 640 F. Supp. 656, 666 found coverage for the cost of SEC and grand jury investigations in addition to the class action securities litigation "because the litigation and investigations [are] each directed at the same allegedly fraudulent activity." Moreover, an adverse outcome to an investigation can jeopardize the defense of the class actions. Adequately preparing witnesses for SEC testimony or reviewing documents in response to SEC subpoenas can be a crucial step in preventing a finding of liability in the class action. So even if the insurer contends that investigation costs are not covered under the D&O policy, an attorney submitting the costs to an insurer for payment should take great pains to point out how costs that might be called investigation costs in fact helped the defense of the civil action.

An insured who purchases liability insurance for claims "arising out of … the rules or regulations of the SEC" should be able to expect that major and basic expenses such as legal research regarding charges raised by the SEC, representation at interviews requested by the SEC, or review of documents compiled by the SEC, are part of the protection purchased.

The author wishes to acknowledge of the assistance of Anthony D. Giles of Farella Braun + Martel in preparing this article.