SafeNet Decision on Related Claims

A CLOSER LOOK AT THE SAFENET DECISION ON "RELATED CLAIMS"

By Jeffrey A. Kiburtz

(Originally published December 21, 2011 at American Bar Association Section of Litigation)

The U.S. District Court for the Southern District of New York recently issued a decision in Fed. Ins. Co. v. SafeNet, Inc., Case No. 09 CV 7863 (Sept. 9, 2011), which addresses a number of issues that frequently arise in claims under directors and officers (D&O) liability policies and other claims-made insurance policies. This article addresses only part of the decision, namely that a claim was related to a “notice of circumstances” made during an earlier policy period, such that both were treated as a single claim made in the earlier policy period. And, while the facts of SafeNet appear to have made this issue one of little practical importance to the parties, the lack of detail in the opinion and seemingly expansive view of when circumstances can be treated as “related” may add confusion to what is already a sufficiently difficult issue.

Overview of Related Claims Provisions

Most claims-made policies (including claims-made-and-reported policies) contain a series of provisions that attempt to have all related claims treated for coverage in a single policy year, irrespective of when the claims are asserted or “made” against the insured. One common provision, usually found in the conditions section, deems all claims asserted against the insured after that policy expires as being made during the policy period if such claims are related to a claim actually made during the policy period. Parallel provisions, usually in the insuring agreement and one or more exclusions, effectively bar coverage for claims made prior to the inception of the policy, including those that actually arise during the policy period but are deemed made in a prior policy period by virtue of the “deemer” clause in the conditions provision. The practical effect of these types of provisions in successive policy years is that, when a claim asserted against the insured in Year 2 is related to another claim made in Year 1, both claims will be subject to coverage under the policy in effect in Year 1, assuming that proper notice of both claims was provided.

While provisions like these are common, if not nearly universal, in modern claims-made policies, there are a number of variations. One common variation, which was at issue in SafeNet, allows the insured to elect to treat pre-claim circumstances as a claim made during the policy period. Thus, if the pre-claim circumstances mature into a claim after the policy expires, or a different claim comes up that merely relates to the pre-claim circumstances, the subsequently made claim will be subject to coverage under the policy in effect when the insured provides notice of the pre-claim circumstances.

Overview of Relevant Facts from SafeNet

On February 8, 2006, SafeNet disclosed that it had failed to properly record certain lease restructuring charges and revenues of a classified government business, resulting in an understatement of about $1.3 million. Shortly thereafter, SafeNet provided “notice of circumstances” related to this understatement (revenue recognition notice) to its primary and excess D&O insurers under 2005–2006 policies that expired shortly thereafter.

Several months later, SafeNet’s problems deepened when it received a subpoena from the Department of Justice and an informal inquiry from the Securities and Exchange Commission (SEC) concerning its options-granting practices. While the court’s opinion states that these investigations ultimately led to “various” civil and criminal enforcement proceedings, it specifically references only two such proceedings: a criminal proceeding brought in 2007 against SafeNet’s former CFO for her role in “backdating” option grants; and an SEC civil proceeding initiated in 2009 against the company and several individuals for engaging in “two fraudulent schemes,” one involving the misdated options and another involving what the court referred to as “other earnings management.” It is not clear what relationship, if any, this alleged “earnings management” had with the circumstances underlying the revenue recognition notice. The criminal case resulted in a guilty plea, and the civil proceeding settled the same day it was filed.

After the disclosure of the investigations in mid-2006, SafeNet shareholders filed various private lawsuits related to the allegedly improper options-granting practices. SafeNet provided its insurers with notice of the various options-related investigations and lawsuits (options notice) under the policies in effect from March 12, 2006 through March 12, 2007.

In 2008, the plaintiffs in one of the shareholder lawsuits filed a first amended complaint alleging that SafeNet made false and misleading statements in its public filings related to its options-granting practices and “SafeNet’s accounting practices for recognizing revenue in product sales.” The court dismissed the claims based on the latter allegations with prejudice on August 5, 2009. The case later settled for $25 million, all of which was presumably allocable to the options issues.

The Court’s Related Claims Decision

Coverage litigation ensued between SafeNet and certain of its excess insurers in the 2005–2006 and 2006–2007 policy periods. Based on what appears to have been fairly standard related claims/deemer provisions in the 2005–2006 excess policy and a prior notice exclusion in the 2006–2007 excess policy, the court concluded that the revenue recognition notice and options notice were related and, therefore, all defense costs and liabilities would be subject to coverage under the 2005–2006 excess policy only. In making this finding, the court noted that “plaintiffs in the Class Action alleged that the financial irregularities disclosed in the February 2006 Notification and the stock options backdating were part of an interrelated course of conduct.” However, there is no real analysis of the issues, nor is there a specific discussion of the facts that the court found to be sufficiently related.

Discussion

In deciding “related claims” issues, policyholders often argue that courts first should consider the overall context. When the effect of an insurer argument that two claims are related is to exclude coverage in its entirety, courts will often adopt a slightly less expansive interpretation. However, when the issue merely decides the period in which the subsequent claim will be subject to coverage, courts often interpret the provisions more broadly, even if the effect is to reduce the amount of coverage available. SafeNet appears to fit into the latter category––the related claims issue determined the policy period in which the claim would be subject to coverage. And, given this context, one might therefore expect a broader interpretation of the “related claims” provision than might be applied in other situations.

However, even if a slightly broader interpretation might be expected under the circumstances, many policyholders likely would find the decision to be excessively broad even by that standard. It would appear that this broad reading resulted from the court’s literal interpretation of the “related claims” provisions. And, while strict construction of policy terms leads to reasonable results in many situations, “related claims” provisions are somewhat unique in that they are often cast in terms far too broad to permit a reasonable, literal construction. For example, the 2006–2007 excess policy in SafeNet excluded coverage for “‘any claim alleging, arising out of, based upon, attributable to or in any way related directly or indirectly, in part or in whole, to’ events described in a specified prior notice of circumstances.” The problem, however, is that the “events described in a . . . notice of circumstances” will almost always include some aspect of mundane, contextual facts that are generally applicable to the insured’s business, like the fact that the company is public and is required to disclose its finances. When coupled with the broad nexus terms (e.g., “in any way related directly or indirectly, in part or in whole”), a literal interpretation can deem virtually any two claims related, no matter how logically or causally dissimilar.

It seems clear, however, that the “related claims” provisions were not intended to capture claims having only a remote or tangential relationship to each other, but rather to deem related two matters whose distinguishing features share a significant logical or causal connection. And, while insurers often assert that the provisions should be interpreted literally in most circumstances, a majority of courts dealing with the nearly all-encompassing breadth of these provisions have declined to do so, and instead have focused on whether the matters share a significant logical or causal connection.

In SafeNet, due to the limited discussion of relevant facts in the opinion, it is not clear why the court decided that the alleged facts underlying the revenue recognition notice and options notice “were part of an interrelated course of conduct.” However, due to the vastly different subject matters of the understatements (revenue recognition and lease restructuring charges versus options-measurement dates), the “interrelationship” could not have been that the claims arose from the same misstatements or even the same types of misstatements. It would seem, therefore, that the “interrelationship” had to have been something more general, perhaps that the understatements appeared in the same SEC filings or the same persons were involved in both. It is also possible that the court found the matters related based on nothing more than generic, seemingly obligatory (for these types of cases) allegations that both understatements arose from a “scheme to defraud investors” or “a culture of corporate greed.”

In any event, due to the lack of any apparent causal or logical connection between the two matters at issue in SafeNet, it appears that the court’s decision was based on a literal reading of the “related claims” provisions with seemingly little regard given to their purpose. And, given the number of other decisions in which courts have adopted more purposive interpretations, policyholders facing similar issues may wish to argue that SafeNet is an outlier among decisions addressing related claims provisions.