KUHN FIRM P.C. Business Lawyers and Litigators
www.KUHNFIRM.com
BULLETIN
Dwight Miller v. St. Paul Mercury Insurance Co., Nos. 10-3839, 10-3856, 10-3883 & 10-3884 (7th Cir., June 29, 2012): Seventh Circuit Reverses Trial Court; Holds That Insured Versus Insured Exclusion Does Not Bar Coverage For Claims Made By Non-Insureds
On June 29, 2012, the Seventh Circuit Court of Appeals entered its opinion reversing the decision of the U.S. District Court for the Central District of Illinois dismissing the complaints brought by John Gorman ("Gorman"), Gary Svec and Strategic Capital Bancorp ("SCB") against their D&O liability insurer, St. Paul. Kevin Kuhn, of Kuhn Firm P.C., Wauconda, Illinois, represented Gorman, a former director of SCB. Gorman had been named as a defendant in a securities suit brought by five plaintiffs, three of whom were former directors of SCB. As former directors, these three plaintiffs qualified as insured's under SCB's D&O policy. The two remaining plaintiffs did not qualify as insureds. St. Paul denied coverage, contending that the Insured v. Insured exclusion bars coverage for the entire suit whenever any plaintiff qualifies as an insured. The District Court agreed. On appeal, the Seventh Circuit held that the Insured v. Insured exclusion applies solely to the claims of those plaintiffs who qualify as insureds. As such, the court held, St. Paul had a duty to defend and indemnify Gorman, Svec and SCB in relation to the claims brought by the two plaintiffs who did not qualify as insureds. The case was remanded to the District Court for further proceedings consistent with the opinion.
Limiting the Personal Liability Exposure of Owners, Officers and Directors of Privately Held Businesses
D&O Liability Insurance Is a Necessity for Privately Held Businesses
Smart business owners, officers and directors know that it is important to protect their personal assets from liability arising out of the conduct of their business. Despite such knowledge, many business people are uninsured for a significant portion of their personal liability exposure. Fortunately, there are readily available insurance products designed to provide the necessary protection.
The most common type of business liability insurance is commercial general liability (or “CGL”) insurance. CGL insurance covers a business against liability for bodily injury, property damage, advertising injury and personal injury. For example, CGL insurance will provide coverage when a customer falls on a slippery floor and breaks his or her leg (bodily injury) or his or her iPad (property damage). CGL insurance will also provide coverage when a business publishes an advertisement that improperly disparages another company or its products (advertising injury) or when a company defames someone by falsely accusing them of failing to pay their bills, or wrongfully trespasses on someone else’s property during construction (personal injury).
CGL insurance will not, however, provide coverage for damages that do not qualify as bodily injury, property damage, advertising injury or personal injury. For example, assume a salesman is accused of wrongfully persuading a supplier to stop doing business with a competitor, resulting in the competitor losing a substantial amount of business. This type of liability, known as tortious interference with a business relationship, will not be covered by CGL insurance because there is no bodily injury, property damage, advertising or personal injury. Rather, the claimant’s damages are purely economic. In addition, assume that a business owner is accused of fraudulently persuading someone to invest in the business or of failing to comply with laws or regulations applying to the business. Again, CGL insurance will not provide coverage for these types of claims because they do not involve bodily injury, property damage, advertising or personal injury. These types of claims can be made by customers, vendors, investors, competitors, suppliers, regulators and creditors.
Directors’ and Officers’ (“D&O”) Liability insurance, also known as Management Liability insurance, will protect business owners and managers from many forms of liability that are not covered by CGL insurance. Although many business people believe that the sole purpose of D&O liability insurance is to protect a corporation against shareholder lawsuits, there are many other sources of liability that business people need protection against. Accordingly, owners, managers and directors of privately held companies need to seriously consider maintaining D&O liability insurance in addition to CGL insurance.
Corporate or Limited Liability Status Does Not Completely Insulate Business Owners, Officers and Directors from Personal Liability
Illinois Law Is Unsettled As To Directors’ and Officers’ Liability for Corporate Acts
Many business owners, officers and directors are under the impression that the corporate or limited liability status of their business insulates them from personal liability for the conduct of the business. Even where they do not hold this misconception, many business people believe that they are insulated from liability as long as they were not actively involved in the conduct giving rise to the liability. This belief is closer to being accurate, but the Illinois Appellate Court recently indicated that the issue is not so clear cut.[i]
Because of this uncertainty under the law, business people must make sure that they are doing everything possible to limit their personal liability exposure, including, but not limited to, obtaining D&O Liability insurance, observing and practicing corporate formalities, retaining directors who are active and involved in the management of the business, entering into stock buy/sell agreements to make sure that ownership does not fall into the hands of an uninterested owner and requiring formal indemnification agreements for corporate directors and officers.
In Zahl v. Krupa, the court reviewed Illinois law on when a corporate officer can be held liable for corporate acts. As for corporate officials who are not directors, the court concluded that, in order to be held liable for corporate acts, the official must have been an active or passive participant in the act. Passive participation means that the official had actual knowledge of the act or omission, but failed to prevent it from occurring. If a corporate official actively or passively participates in a wrongful act, he or she can be held personally liable, even though he or she was acting for the corporation in the commission of the act or omission. As for directors, however, the court found that a director may be held liable for the acts of subordinates (i.e., officers) if he or she merely failed to exercise “ordinary care” in the supervision of the subordinate. This distinction is critical. It means that a director can be held liable for the acts of an officer or other subordinate if the director knew or “should have known” of the improper conduct, yet failed to prevent it.
Examples of situations in which a director can be held personally liable include where he or she negligently fails to ensure that an officer is qualified for his or her position or fails to make a proper inquiry, despite knowledge of potentially improper activities by the officer.
Piercing the Corporate Veil
Corporate Veil of Protection From Liability May Be Pierced Where Necessary To Achieve Equity
"The corporate veil allows an entity's investors to limit their liability and thus encourage investment." Wachovia Securities v. Banco Panamericano, No. 10-1203 (7th Cir. 2012). "Yet courts may pierce a corporation's veil and hold the individual investors personally liable for the underlying claim if the corporate form is used as a cloak or cover for fraud or illegality, to work an injustice, to defend crime, or to defeat an overriding public policy, or where necessary to achieve equity." Id. Under Illinois law, a two prong test is applied to determine whether a corporate veil can be pierced: (1) there must be such a unity of interest that ownership and the separate personalities of the corporation and the individual no longer exist; and (2) circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice.
A court will look at the following factors to determine whether the first prong of the test is satisfied:
- inadequate capitalization of the corporation (i.e., did the shareholders actually "invest" capital in the company?);
- failing to issue stock ;
- failing to observe corporate formalities (such as holding regular board meetings, issuing resolutions, etc.);
- failing to pay dividends;
- corporate insolvency (i.e., the corporation itself has little or no money to pay creditors);
- nonfunctioning corporate officers (i.e., organizers name officers, but such persons do not actually perform corporate duties);
- missing corporate records (such as Articles of Incorporation, Bylaws, resolutions, Minutes of Corporate Board and Shareholder Meetings, etc.) ;
- commingling corporate and personal funds;
- diverting assets to an owner or other entity to creditor detriment (i.e., corporation transfers property to owner or related company to avoid attachment by an unpaid creditor of the corporation) ;
- failing to maintain an arm's length relationship among related entities (i.e., transferring funds between entities without supporting paperwork and accounting records, one entity paying the debts of another entity without any supporting consideration for doing so, etc.);
- and whether the corporation is a mere facade for a dominant owner (i.e., owner treats corporate assets as his own and utilizes corporate form solely to avoid personal liability).
It is important for corporations and their owners to pay attention to the above factors, particularly as they grow. It is (usually) never too late to start practicing proper corporate behavior in order to avoid personal liability of the shareholders. For example, a company that has never held regular corporate meetings can start doing so, along with maintaining minutes of same; a company that has not kept proper corporate records can, in many circumstances, recreate them and then start maintaining proper records going forward; a company that has previously failed to pay dividends can institute a practice of doing so; and a company that has nonfunctioning officers can replace current officers with persons that serve a corporate business purpose.
The lawyers at Kuhn Firm P.C. are experienced in counseling business owners, officers and directors on the insurance and risk management issues discussed above and welcome any inquiries on these or other issues of concern.
Please feel free to contact us at 847-416-2002 to arrange an appointment or telephone conference, or to subscribe to our bulletins.
This bulletin is not intended to constitute legal advice. Before taking action on any of the items discussed herein, you should consult with an attorney.
Chicago Suburban Office: 227 N. Main Street, Wauconda, Illinois 60084
Chicago Loop Office: Three First National Plaza, 70 W. Madison Street, Suite 1400, Chicago, IL 60602
Phone: 847-416-2002 Fax: 847-416-4798
