An appellate court ruling that says a Liberty Mutual Insurance Co. unit is not obligated under its directors and officers policy to pay more than $3 million in costs associated with an informal U.S. Securities and Exchange Commission investigation illustrates the importance of policyholders obtaining this coverage, experts say.

But while some insurers have begun to offer coverage for preclaim investigative costs for entities, it can be costly, says one expert.

The SEC informed Denver-based MusclePharm Corp. in May 2013 that it was conducting an inquiry into the company and requested that it voluntarily produce documents, according to last week’s ruling by the 10th U.S. Circuit Court of Appeals in Denver in MusclePharm Corp. v. Liberty Insurance Underwriters Inc.

The SEC issued an “Order Directing Private Investigation and Designating Officers to Take Testimony” to MusclePharm in July 2013, according to the ruling. It subsequently issued 21 subpoenas to the company and individual officers and directors, according to the ruling.

In February 2015, the SEC issued Wells notices to two company officers, stating it had made a preliminary determination to recommend the commission file an enforcement action against the officials. A Wells notice is an alert that the SEC’s enforcement divison recommends the full commission act against the recipient.

The parties settled in September 2015, and the SEC issued cease-and-desist orders against MusclePharm and four executives. According to an SEC statement at that time, its investigation found MusclePharm had omitted or understated nearly half a million dollars’ worth of perks bestowed upon its executives.

Without admitting or denying the SEC’s findings, the company agreed to pay $700,000 in penalties, while three of the individuals paid a total of $210,000, according to the SEC.

Meanwhile, Liberty Mutual denied MusclePharm’s request for the more than $1.3 million it had spent in legal and related expenses and the more than $1.7 milion it had spent in responding to the SEC investigation.

MusclePharm filed suit against the insurer, and the U.S. District Court in Denver ruled in favor of the Boston-based Liberty Mutual unit.

A three-judge appeals court panel unanimously affirmed the lower court’s ruling.

“Under the policy, the insured does not have a covered ‘claim’ without an allegation for wrongdoing against an insured person, and the SEC stated in both the July 8 Order and the related subpoenas that these documents were not alleging wrongdoing,” said the ruling.

“Specifically, these documents noted, ‘The commission has not determined whether any of the persons or companies mentioned in the order have committed any of the acts described or have in any way violated the law,’” the ruling said in affirming the lower court’s ruling.

“This is a very insurance-friendly decision that allows (the insurer) to avoid coverage for a significant expense as part of the investigation,” said John O’Donnell, a partner with Herbert Smith Freehills L.L.P. in New York.

“There are significant time and costs associated with an investigation that occurs” before the government makes charges. In this case, “because the language of the policy was so specific, MusclePharm was not able to recover any expenses” until the Wells notice, Mr. O’Donnell said.

It is a “very reasonable and strong ruling” that is based on the “plain meaning” of the policy’s language, said insurer attorney Michael L. Manire, a partner with Manire & Galla L.L.P. in New York.

The ruling “highlights the importance of making sure you have the right language in the insurance policy when you are negotiating for these things,” said Paul R. Walker-Bright, a partner with Reed Smith L.L.P. in Chicago.

“You can tell the court was very focused on the particular language that was used in the definitions of ‘claim’ and ‘wrongful act,’ and they applied particularly narrow interpretations of some of that language,” he said.

Kevin LaCroix, executive vice president of RT ProExec, a division of R-T Specialty L.L.C., in Beachwood, Ohio, said the issue of preclaim investigation costs “is an ongoing issue, and it comes up all the time.” While the insurer and policyholder agreed in this case that there was a claim once the Wells notices were issued, “the problem is a great deal of fees were incurred before.” The ruling raises the issue of how pre-investigation costs can be insured, “given the traditional structure of the D&O insurance.”

“The question is whether a subpoena is a request for nonmonetary relief within the meaning of the policy. This court said no,” said Mr. LaCroix. The answer in other policies will depend upon policy language, he said.

Mr. LaCroix said in the last 24 months or so, some insurers have begun to offer a policy extension that provides coverage for entity investigative costs. It requires additional underwriting, however, “and
usually additional premium” of about 20% more, he said.

Policyholders must affirmatively seek the coverage, and the insurer must be willing to offer it, he said. The additional premium “is a sticking point,” he said. Many buyers wind up not getting the coverage, while some “are persuaded they need it and do buy it.”