Recent Court Rulings: A Win for D&O Policyholders and a Warning on AI Risk

Intro (00:00):
You are listening to the Alliant Specialty Podcast, dedicated to insurance and risk management solutions and trends shaping the market today.

Mike Radak (00:09):
Welcome back to another episode of Alliant Specialty's Claims and Legal podcast, where we discuss some of the latest legal developments in the financial lines insurance world. I'm Mike Radak, the head of Alliant Specialty Claims and Legal team. In addition to the guidance and advocacy that our team of attorneys offer our clients, we also work very hard to try and keep our finger on the pulse of relevant court decisions in this space. Today, I'm going to be talking about one of those decisions. It's a case where a carrier tried to make a broad interpretation of a public offering exclusion in order to avoid its obligations in covering a claim. In this case, the court ultimately sided with the policy holder. Later, David Finz is here with me, and he's going to tell us about latest developments affecting the cyber insurance world. As always, if you'd like to read more about these cases, please check out our monthly Executive Liability Insights newsletter, and please reach out to David or I to get added to the mailing list for that newsletter if you don't already get it.

In the D&O insurance space, the EB Holdings case out of Nevada is worth taking a look at, particularly for how it treats the public offering exclusion, which continues to be one of the most litigated and misunderstood provisions in private company and pre-IPO risk. At a high level, the insurers argued that coverage should be barred because the underlying investor litigation was connected to a public offering or solicitation of securities. That's a familiar move that we see carriers trying to do in claims with similar fact scenarios pretty regularly here. In this case, the insured was accused of orchestrating illegal price fixing schemes to inflate the value of their securities on the secondary market and allegedly fraudulently induced investors to buy them. The investors sued the insured for fraud, breach of fiduciary duty and a host of other related allegations. They sought coverage under their D&O insurance policies, and the carrier's denied coverage based on the policies specific entity exclusion and the public offering exclusion, which led to coverage litigation.

In this policy, the public offering exclusion applied to claims alleging, arising out of, based upon or attributable to any public offering of securities by the company. It was very broad exclusionary language, at least at the intro to that exclusion. The carrier in this case argued that public offering should apply to any form of offering. While the insured argued that the term should be limited to securities offered broadly to potentially unsophisticated groups of investors, similar to an offering that would require filing regulators under certain SEC and other requirements. The insured insisted that its offering was limited to a small of investors and should be classified as a private offering. The court went through several definitions of the terms both public and offering interpreting this dispute, primarily because public offering was not a defined term in the policy. The court noted that the word public appears to act as a qualifier here because the next paragraph in the policy uses the language, any purchase or sale of securities, which better reflects the carrier's interpretation.

While the policy drafters certainly could have used that language, they chose not to here. Applying the relevant law to the interpretation of public offering favored the insured's interpretation and their arguments. The court did look into the causation between the wrongful acts and the public offering, but it focused on kind of the threshold question here, which was this even a public offering. The court determined that answer was no. That's a big deal because it means the exclusion actually has some boundaries here and doesn't automatically apply every time a company raises money. As you know, many insurance carriers try to hold that it does. The court also addressed the specific entity exclusion on the policy and determined that the exclusion was ambiguous and, therefore, accepted the insured's reasonable interpretation of the policy and held that the specific entity exclusion did not apply. Finally, the court also determined that this was an antitrust claim, which required a sub-limit of coverage to apply here.

What are the practical takeaways from this case? Don't assume that if a claim involves an offering to raise capital, that it automatically triggers the exclusion. The exclusion should only be triggered by a public offering, which if it's not defined in the policy, has some nuance to those terms that the court's going to interpret. Courts will also weigh certain extrinsic factors when determining the application of the exclusion. In this case, they looked at investor sophistication and the fact that the offering had limited distribution. Our team spends a lot of time crafting and revising policy language to make sure we get it right. In this case, you would've wanted to scrutinize how that public offering exclusion is worded. Try to narrow it and make sure it's not tied to actual offerings, planned offerings or any solicitation activity. You want to watch for policies that extend the exclusion to private placements or informal capital raises, which can dramatically broaden its reach.

As with every coverage dispute, we say don't concede to the carrier's position and a denial of coverage early. We can almost always craft an argument for coverage, so don't accept denials without really digging in on the carrier's rationale for denying the claim. The real lesson from the EB Holdings case is even in a case where insurers successfully limited coverage through other mechanisms like sub-limits and claim aggregation, the public offering exclusion did not become the catchall escape hatch that the carriers were hoping for here. Again, this is a favorable ruling from the policy holder perspective, and kudos to the court for doing the proper analysis and getting it right. Now, let's hear from David and what's new and exciting in the legal world of cyber insurance.

David Finz (06:06):
Thanks, Mike. In the next issue of our Executive Liability Insights newsletter, we're going to be shining a light on a development we're seeing at the state level, which is a rise of regulation around artificial intelligence. As recently reported by Law 360, three states, California, Oregon and Washington, have already enacted laws allowing consumers to bring lawsuits against artificial intelligence companies for the harm that those users allegedly sustained while using chatbots. Another 27 states are considering similar legislation that would impose liability against AI companies. The nonprofit group, Public Citizen, which is a proponent of such legislation, says that one of its goals is to protect minors from harm resulting from their interactions with chatbots. Now, psychologists have expressed concern that the use of chatbots may adversely impact the development and the wellbeing of children and teens. Another purpose of these laws is to require businesses to embed code in models that would distinguish deep fakes and identify any content such as video, still images or audio that have been created or altered by AI.

Some legislation even requires the equivalent of a digital watermark to make it easier for users to identify the origin of the content as well as to be able to distinguish whether it's been modified. Now, these legislative initiatives may run counter to the national framework that was advanced earlier this year by the Trump administration, which had sought to preempt state-level efforts to regulate AI on grounds that these divergent regulatory schemes could prove burdensome for businesses that are developing this technology. In the meantime, what are businesses to do? We don't know what the trajectory is going to be of this state legislation. We know that there are three states with laws already on the books that may or may not get challenged by the federal government. In the meantime, any companies that are utilizing chatbots, and we can find these in hospitality, FI, retail, healthcare, that interact with users, would be well advised to institute age verification procedures and also to incorporate features that enable them to trace the history of any content that is uploaded or generated by the model to see whether it in fact has been modified along the way.

These measures will help insulate the company from liability further down the road if in fact they find themselves in the crosshairs of any of these state laws that have either been enacted or are currently being considered. With that, I'll turn it back over to you, Mike.

Mike Radak (08:56):
Thanks, David. It seems like we'll probably be discussing developments in the AI landscape until you and I both retire, but interesting stuff. Thanks everybody for spending a few minutes with us insurance nerds today and listening to us talk insurance. If you'd like to learn more about these and other recent developments, please reach out and subscribe to our Executive Liability Insights monthly newsletter. If you'd like more information on Alliant and a more rewarding way to manage risk, please visit our website at www.Alliant.com. Thanks for listening.