Officers and directors face a variety of risks of incurring personal liability. The large number of shareholder suits that are filed every year alleging failure of the officers and directors to disclose properly the financial condition of their companies coupled with the increased stringency of financial disclosure requirements imposed by the Sarbanes-Oxley Act, creates a heightened level of concern for officers and directors who oversee financial disclosure. To address these risks, companies typically purchase insurance policies (D & O policies), which generally contain exclusions for claims based on environmental matters. The scope of these exclusions, specifically the extent to which these exclusions can be read to address shareholder claims for alleged failure to disclose potential environmental risks and liabilities of the company to shareholders, is an increasingly important issue for directors and officers and their companies.
This question was the subject of recent opinions by the federal Fifth and Sixth Circuit Courts of Appeal. Although the two courts arguably reached differing conclusions as to whether environmentally-related exclusions apply to shareholder claims, read together against the backdrop of the state laws that each court applied and the specific language of two different exclusions involved in each case, the two opinions might provide a preliminary road map for evaluating these types of coverage issues. The Sixth Circuit, applying Ohio law, held that an asbestos exclusion was not clear enough to exclude claims based on financial disclosure of company liability for asbestos claims. The court reasoned that the asbestos issues were too removed causally from the alleged financial misrepresentation. The Fifth Circuit applied Texas law and held that a broad pollution exclusion did not cover the alleged failure of the officers and directors to disclose potential environmental liabilities known to the officers and directors.
The apparent divergence in the opinions resulted in part from the differences in the language used in each exclusion. The pollution exclusion construed by the Fifth Circuit used terms such as “directly or indirectly” and specifically referred to claims alleging damages to the company or its securities holders. The asbestos exclusion, construed by the Sixth Circuit, did not. The Sixth Circuit opinion may suggest some protection may be afforded under D & O policies for suits alleging improper disclosure regarding asbestos litigation under the wording of the particular policy. The Fifth Circuit case illustrates a risk to officers and directors and their companies that they may not be effectively insured from liability under D & O policies from shareholder litigation alleging improper or insufficient environmental disclosure.
In the Sixth Circuit case, Owens Corning v. National Union Fire Insurance Co. of Pittsburgh, PA., No. 97-3367, 1998 WL 774109 (6th Cir. Oct. 13, 1998), the court concluded that the asbestos exclusion in the D & O policy obtained to protect the officers and directors of Owens-Corning and the company itself did not exclude coverage for shareholder derivative claims for misrepresentation of or failure to disclose the potential liability of the company for asbestos-related claims. The underlying claim in the Owens Corning case involved shareholder assertions that the officers and directors failed to disclose adequately and misrepresented the potential liability of the company for asbestos litigation. The alleged misrepresentations focused on notes in the financial statement on contingent asbestos litigation liabilities. The class action lawsuit was
settled for almost $10,000,000. Id. at *2.
The court’s analysis focused on whether the exclusion, which clearly excluded claims for
liabilities directly caused by asbestos exposure, was broad enough also to preclude claims for misrepresentation of or failure to disclose the liability for those claims. The district court had ruled that the claims relating to financial disclosure of asbestos liability were excluded from coverage under the National Union D & O policy.
The Sixth Circuit did not agree. The court analyzed the exclusion under Ohio law, which
the court held provided for a narrow construction of insurance policy exclusions. The court interpreted Ohio law to require that the exclusion be “specific, clear, and exact.” This turned out to be a very strict test, as applied by the Sixth Circuit. The critical question was whether the claims for inaccurate financial disclosure of asbestos liability were “based upon, arising out of, or related to” asbestos, use of asbestos or asbestos products liability claims. Id. at *4.
The court’s opinion defined these three terms. First, the court concluded that the class action suit was not “based upon” the use of asbestos or any product liability issue, but was a claim regarding financial disclosure. Id. Second, as for “arising out of” products liability for asbestos products, the court reviewed Ohio law and concluded that there must be a direct causal relationship between the initial event and the damages claimed. In the context of a claim based on financial disclosure, the court determined that the asbestos use or injury were too distant from the alleged wrongdoing for the financial disclosure claim to be deemed to arise out of the asbestos activity of the company. The court ruled that it was the misrepresentations–and not the asbestos products–that were the cause of the harm the plaintiffs alleged. Id. at *4-5. Third and finally, the court ruled that the claims did not “relate to” asbestos matters.
Since the business of Owens Corning primarily involved asbestos, if all shareholder derivative claims related to asbestos were excluded, the court reasoned then that the policy would effectively exclude all shareholder claims. The court believed this result would be inconsistent with the intent of the policy. Id. at *5.
In National Union Fire Insurance Co. Pittsburgh, P.A. v. U.S. Liquids, Inc, 2004 U.S.
App. LEXIS 2694 (5th Cir. Feb. 17, 2004), the Fifth Circuit ruled that a director and officer insurance policy effectively excluded claims filed by shareholders against directors and officers alleging they failed to disclose environmental liabilities in filings with the Securities and Exchange Commission and in press releases. In this case, the company and its directors and officers sought to reverse a declaratory judgment issued by the federal district court that the pollution exclusion in the company’s D & O insurance policy excluded any claims filed by shareholders against the directors and officers alleging that the stock price of the company had fallen when previously undisclosed environmental liabilities of the company became known to the public.
In the underlying lawsuits, the plaintiff shareholders alleged U.S. Liquids had acquired other waste management businesses without regard to their environmental liabilities and without disclosing the environmental practices or liabilities of these companies to shareholders. Id. at *3-4. An FBI investigation of operations of one of the acquired companies discovered what the government alleged was the knowing discharge of hazardous wastes into a city sewage system and the knowing illegal transport and disposal of hazardous waste. This investigation led to an expensive cleanup and the closure of one of the acquired company’s waste management facilities. Id. at *5. The shareholder plaintiffs alleged the directors and officers actively concealed the illegal activities of the acquired company from the shareholders and the public. When this information became known to the public, the price per share of U.S. Liquids fell $10.75. Trading of the company’s stock was halted for six days and analysts downgraded the rating of the stock. Id.
In interpreting the pollution exclusion under Texas law, the Fifth Circuit noted that it applied to any loss in connection with a claim “alleging, arising out of, based upon, attributable to, or in any way involving, directly or indirectly” pollution matters. Id. at *2-3. The exclusion specifically stated “including but not limited to a Claim alleging damage to the Company or its securities holders.” Id. at *3. In particular, the court cited Texas case law holding that the exclusion in an insurance policy “need only bear an incidental relationship to the described conduct for the exclusion to apply.” Id. at *8. The court applied a “but for” test, and concluded that “but for” the underlying illegal activities related to pollution, there would be no shareholder claims against the officers and
directors. Id. at *17.
Taken together, the Owens Corning and U.S. Liquids cases highlight the importance to officers and directors of understanding their obligations to review and disclose environmental liabilities of the public companies they manage. Not only are companies and their officers and directors potentially exposed to claims for failure to make proper environmental disclosure, but if the D & O policies contain broadly-worded pollution exclusions, particularly in jurisdictions in which such exclusions are loosely construed, the officers and directors, and any company that is obligated to indemnify its officers and directors, may be exposed to an uninsured risk. If coverage is not included in the policy, is ambiguous, or is otherwise a concern, the company may want to consider evaluating additional insurance or endorsements to existing policies to protect the officers and directors in the event a claim is asserted relating to environmental disclosure.