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PEPSICO, INC. v. CONTINENTAL CAS. CO.

June 23, 1986

PEPSICO, INC., Plaintiff,
v.
CONTINENTAL CASUALTY COMPANY, Defendant



The opinion of the court was delivered by: BRIEANT

MEMORANDUM & ORDER

Brieant, J.

 Plaintiff PepsiCo, Inc. ("PepsiCo") brought this action against defendant Continental Casualty Company ("Continental") to recover money paid to settle litigation on behalf its officers and directors; it also asserts claims against Continental for fraud and antitrust violations. Continental had issued a policy insuring PepsiCo's directors and officers from certain claims against them. PepsiCo now seeks an interpretation of the underlying policy agreement in the form a partial summary judgment motion. Continental has moved to dismiss various portions of the complaint.

 PepsiCo announced to the public in November 1982 that it had discovered "accounting irregularities" in several of its international operations, including Mexico and the Philippines. Employees in those countries had falsified accounts to improve the apparent performance of their operations. PepsiCo consequently had to restate its consolidated earnings for 1978-1981 and the first three quarters of 1982.

 Predictably, several suits under well-known Rule 1Ob-5 were filed against PepsiCo, its directors and officers, its accounting firm, Arthur Young & Co., and a former officer, Richard Ahern, alleging a "fraud on the market" because of the false financial statements. These suits were consolidated before then Judge Abraham D. Sofaer of this district. The consolidated amended complaint alleged violations on the part of all defendants of Section 10 of the 1934 Securities Act as well as a common law claim for fraud and reckless and negligent misrepresentation. On August 23, 1984, Judge Sofaer certified a class for the Securities Act claim.

 In February, 1983 the Securities and Exchange Commission also initiated an investigation into the circumstances of the PepsiCo false financials to determine whether PepsiCo or its directors and officers had violated any of the federal securities laws. As part of this investigation the S.E.C. interviewed PepsiCo officers and managers and partners and employees of Arthur Young & Co. The S.E.C. subsequently charged PepsiCo with violations of certain anti-fraud and reporting provisions of the Securities Act. Mr. Ahern was indicted by a Federal Grand Jury and pled guilty to criminal charges of fraud. He was sentenced in April 1984.

 On March 4, 1985 attorneys for PepsiCo, its inside directors and its outside directors reached a tentative settlement agreement with class plaintiffs' counsel. PepsiCo counsel approached Continental seeking its approval of the proposed settlement. When they were unable to reach an accord on the settlement because of time pressures, PepsiCo and Continental entered into a non-waiver agreement. By this agreement Continental obtained the right to review the settlement after the fact but without losing its right under the policy to object to the reasonableness of the settlement.

 The Class Action parties entered into a stipulation of settlement on March 15, 1985 and Judge Sofaer approved the settlement as fair, reasonable and adequate on April 26, 1985, after having expressed himself as "shocked, quite suprised at the amount." (Ex. F. Simon affidavit at 10). Under the terms of the settlement, PepsiCo paid $22,067,754 into a Settlement Fund. In exchange, plaintiffs in each of the actions released all defendants from liability. All of plaintiffs' claims against all defendants, including the non-certified common law or state law claims were dismissed with prejudice.

 The Directors and Officers Liability Policy at issue here covered the period July 28, 1981 to July 28, 1984. After extending that coverage for thirty days, PepsiCo and Continental agreed to a new policy for the period August 27, 1984 to August 27, 1987. Both policies included a provision permitting either party to cancel the policy unilaterally. Pursuant to that provision, Continental cancelled the 1984-1987 policy effective June 29, 1985.

 PepsiCo Motion for Summary Judgment

 By its motion for partial summary judgment PepsiCo has asked this Court to make the following four interpretations of the underlying policy. First, that Continental had a contemporaneous duty to pay the defense costs to the directors and officers as they incurred them. Second, that nothing in the directors and officers policy and no public policy precludes reimbursement to PepsiCo for the settlement and defense costs. Third, that Continental cannot pro rate its payments on the directors and officers insurance policy according to relative degrees of liability as between the insured and other defendants including the corporation. Fourth, if Continental is permitted to make some allocation according to degree of fault, then it should bear the burden of proving liability on the part of the corporation itself and Arthur Young.

 Contemporaneous Duty to Pay Defense Costs

 The parties agreed at the time the policy was issued that a "loss" should include the cost of defending legal actions brought against directors and officers for "Wrongful Acts." The policy definition of Loss states that,

 
"Loss shall mean any amount which the Directors and Officers are legally obligated to pay for which they are not indemnified by the Company, or for which the Company may be required or permitted by law to pay as indemnity to the Directors and Officers, for a claim or claims made against them for Wrongful Acts, and shall include ... amounts incurred in the defense of legal actions, claims or proceedings and appeals therefrom ..." PIII.(d) of Policy, Ex. 1 to Rolfe Affidavit.

 The "Wrongful Acts" covered by this policy do not include all tortious acts. According to the policy definition, "Wrongful Acts" means "any actual or alleged error or misstatement or act or omission or neglect or breach of duty by the Directors and Officers in the discharge of their duties ... or any other matter not excluded by the terms and conditions of this policy claimed against them solely by reason of their being officers and directors of the Company." § III.(c). of Policy, Ex 1 to Rolfe Affidavit (emphasis added). The policy excludes coverage for any payments "brought about or contributed to by the dishonesty of the Directors or Officers." The policy will cover, however, the costs of defending the directors and officers against alleged dishonesty " unless a judgment or other final adjudication thereof adverse to the the directors and officers shall establish that acts of active and deliberate dishonesty committed by the Directors and Officers with actual dishonest purpose and intent were material to the cause of action so adjudicated." PIV.(b)(5) of Policy, Ex. 1 to Rolfe Affidavit (emphasis added).

 Continental contends that it is not liable for immediate payment to PepsiCo for the directors and officers legal fees because Paragraph VI of the Policy provides that "no costs, charges or expenses shall be incurred without Underwriters' consent." Continental argues that it could not pay the directors' and officers' legal fees until the conclusion of the litigation because there remained the possibility that a final adjudication would include a finding that the directors or officers had been materially dishonest. Paragraph VI includes a declaration that Continental will pay the amounts due except as limited by the exclusions listed in Paragraph V of the policy.

 Although this language would have entitled Continental to reimbursement of payments for the defense costs of directors and officers adjudicated as dishonest, it does not excuse Continental from its obligation to pay the defense costs as they are incurred. First, under the policy, entry of final judgment is not a prerequisite to payment of defense costs. The policy definition of loss includes amounts incurred in the defense of all allegations of wrongdoing and dishonesty. Thus, the duty to pay defense costs essentially applies to all legal actions against the directors arising out of their status as such. Continental promised to pay "on behalf of" the directors and officers "all loss which [they] shall become legally obligated to pay." P I(a) to Policy, Ex. 1 to Rolfe Affidavit. Thus, once the "loss" or attorneys fees were incurred by the directors and officers, C.N.A.'s responsibility to reimburse the directors and officers attached.

 A similar directors and officers policy was also interpreted recently to require contemporaneous payments of defense costs. Okada v. M.G.I.C., 608 F. Supp. 383 (D. Hawaii 1985). In that case, shareholders of a bankrupt savings and loan sued the directors and officers claiming that their negligence caused the collapse of the institution. As in this case, that policy did not impose a "duty to defend" upon the insurer although the definition of loss included "defense costs." The Court explained that,

 
"the absence of policy language explicitly imposing a duty to defend does not mean that the policy does not require the insurer to pay defense costs. Like liability arising from a judgment or settlement, attorneys fees are compensable losses under [the policy definition]. The only difference is that such fees come due earlier than any possible adverse judgment." Id. at 385.

 Second, a liability insurer has a duty to pay all defense costs until it can confine its duty to pay only on those claims it has insured the policy holders against. Shapiro v. American Home Assurance Company, 616 F. Supp. 906, 913 (D. Mass. 1985). Continental could, excuse itself from the contemporaneous duty only if it could establish as a matter of law that there was no possible factual basis on which it might be obligated to indemnify the directors and officers. Villa Charlotte Bronte, Inc. v. Commercial Union, 64 N.Y.2d 846, 848, 487 N.Y.S.2d 314, 476 N.E.2d 640 (1985). Here Continental was obligated to pay incurred defense costs unless a final judgment found "material dishonesty" by the directors or officers. Continental has conceded that even if a final judgment had been entered such a conclusion was highly unlikely. Continental consequently had an obligation under the Policy to pay the directors' and officers' defense costs as they were incurred.

 The Terms of the Policy and Public Policy

 A class was certified against defendants only on the federal claim that they had violated Section 10(b) of the Securities Exchange Act, 15 U.S.C. § 78j(b) and SEC Rule 10(b)-5. Liability under those provisions requires that plaintiffs prove intentional or reckless misconduct on the part of defendants. Continental claims as its seventh affirmative defense that a finding of liability on these claims would fall within the dishonesty exclusion of the Policy (PIV.b.5), and it should therefore not be held responsible to insure the directors and officers on the claims. Continental also asserts that indemnification against such charges is contrary to "public policy."

 Insofar as concerns defense costs, this argument adds nothing. Under the terms of the policy, Continental agreed to pay all costs for defending and settling claims for actual and alleged Wrongful Acts. The exclusion for "dishonesty" attaches only after a "final judgment or other final adjudication" implicates the directors. Such a finding is no longer possible in this case. The class action claims have been dismissed with prejudice and although the S.E.C. investigation resulted in charges against PepsiCo, none were asserted against any of its directors or officers. Continental cannot now put the directors and officers other than Ahern on trial to determine whether or not they were, in fact, dishonest to the point that the policy will not cover them.

 The policy at issue here is critically different from the one at issue in Stargatt v. Avenell, 434 F. Supp. 234 (D. Del. 1977), cited by defendant. The insurance company in that case was permitted to contend that the directors' and officers' dishonesty barred reimbursement under the policy. That policy's dishonesty exclusion, however, was unconditional and did not predicate its applicability upon a "final judgment or other final adjudication." Compare Id. at 242-242, with PIV.(b)(5) of Policy, Ex. 1 to Rolfe Affidavit.

 Public policy also does not bar reimbursement of the defense and settlement costs. Continental agreed to reimburse PepsiCo for such payments whenever PepsiCo "may be required or permitted by law" to indemnify its directors and officers. Continental suggests that Delaware Corporation Law bars corporate indemnification of settlements involving alleged Rule 10-(b)(5) violations, and that even if it does permit indemnification for such claims, a genuine issue of material fact remains as to whether the PepsiCo directors' indemnification decision was procedurally flawed.

 Continental refers to the Delaware Corporation Law, § 145, which provides when, and under what conditions, a corporation may indemnify its directors and officers. Section 145(a), for example, permits indemnification when a director or officer "acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation." Section 145(d) establishes the appropriate manner for making the determination that the director or officer "has met the applicable standard of conduct." PepsiCo's failure to satisfy these procedures or even to make an evaluation of the directors and officers actions is made irrelevant by the fact that these Provisions are not exclusive conditions for indemnification. The statute itself makes clear that these are simply "fall back" provisions which a Delaware corporation may or may not adopt. Section 145(f) of the Delaware Code states that "the indemnification provided by this section shall not be deemed exclusive of any other rights to which those seeking indemnification may be entitled under any by-law, agreement, vote of stockholders ...


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