Delaware Federal Court: No Coverage Under D&O Policy For Claims Based On Acts Alleged To Have Occurred Prior To Insured Entity’s Formation

Applying Delaware Law, the United States District Court for the District of Delaware has held that there is no coverage for acts undertaken by an insured’s directors and officers that occurred prior to the formation of the insured corporation. Liberty Ins. Underwriters, Inc. v. Cocrystal Pharma, Inc., 2022 WL 1624363 (D. Del. May 23, 2022).

The insured corporation was formed through a reverse merger. Following the merger, the SEC served a subpoena duces tecum on the insured in connection with an investigation (“SEC Investigation”) of both the insured and a predecessor company. Additional subpoenas were served on individuals who were directors and officers of both the insured and the predecessor company. The SEC ultimately filed an enforcement action (the “SEC Action”) against the directors and officers, alleging that they had engaged in a “pump-and-dump scheme” to inflate the value of the predecessor company. After the SEC Action was filed, the insured was sued by multiple shareholders in derivative actions. The insured tendered the SEC Action and the derivative actions to its D&O insurer.

The insurer filed a declaratory judgment action, seeking a judgment that the policy did not cover the SEC Investigation, SEC Action, or the derivative actions, and also that the insurer did not engage in bad faith conduct. The insurer further sought to recoup defense costs that it had advanced to the insured in connection with the SEC Investigation. The insured filed a counterclaim for breach of contract, declaratory judgment, bad faith, reformation of contract, and violation of statutory duties under Washington state law. The parties filed cross-motions for summary judgment. With one exception involving a claim under Washington state law, the court ruled in favor of the insurer on all counts.

According to the court, the pump-and-dump scheme underlying the SEC matters did not constitute a “Wrongful Act,” which the policy defined as “any actual or alleged error, misstatement, misleading statement, act, omission, neglect, or breach of duty, actually or alleged committed or attempted by the Insured Persons in their capacities as such.” The court reasoned that none of the individuals engaged in the scheme in their roles as directors and officers of the insured organization but, rather, acted in their capacities as directors and officers of the predecessor company.

The court also determined that there was no coverage for the derivative actions, which were Claims not made until after the policy had expired. According to the court, the policy’s relation-back provision did not bring the derivative actions within coverage because the underlying pump-and-dump scheme “is neither a Wrongful Act nor an Interrelated Wrongful Act” so “there is nothing to which the Derivative Actions could relate back.”

The court granted the insurer’s claim for recoupment because the plain language of the policy stated that “[i]f it is determined by . . . litigation . . . that any such Defense Costs are not covered under this Policy, the Insureds agree to repay the Insurer the amount of such Defense Costs not covered.” The court rejected the insured’s contention that the insurer had waived the right to recoup, observing that “the doctrine of waiver does not operate to expand or create coverage that the Parties did not negotiate and for which the Policy does not provide.”

Notably, the court followed Delaware choice-of-law principles and evaluated the matter under Delaware law, stating: “Delaware court[s] consistently have held that Delaware law applies to disputes over [D&O] insurance coverage where, as here, the insured companies are Delaware corporations.”