Level 3 Communications, Inc. v. Federal Insurance Company

In the
United States Court of Appeals
For the Seventh Circuit
No. 01-1806
Level 3 Communications, Inc.,
Plaintiff-Appellee,
v.
Federal Insurance Company,
Defendant-Appellant.
Appeal from the United States District Court
for the Northern District of Illinois, Eastern Division.
No. 96 C 5346--George W. Lindberg, Judge.
Argued October 25, 2001--Decided November 26, 2001
Before Bauer, Posner, and Evans, Circuit
Judges.
Posner, Circuit Judge. This appeal comes
in a diversity suit seeking damages from
a pair of insurance companies a primary
carrier, Federal, and an excess carrier
that’s no longer a party) that refused to
pay on a policy of directors’ and
officers’ liability insurance, a "D&O"
policy, as it’s known. Despite its name,
such a policy insures not only officers
and directors themselves but also their
corporation if, as happened here, the
corporation indemnifies them for their
liability. This is known as "company
reimbursement coverage," as distinct from
"direct" coverage of the directors and
officers. E.g., Ratcliffe v.
International Surplus Lines Ins. Co., 550
N.E.2d 1052, 1056 (Ill. App. 1990);
Caterpillar, Inc. v. Great American Ins.
Co., 62 F.3d 955, 957 (7th Cir. 1995);
Harbor Ins. Co. v. Continental Bank
Corp., 922 F.2d 357, 359 (7th Cir. 1990).
The district court granted summary
judgment for Federal initially on the
ground that one of the plaintiffs,
Pompliano, in the suit against Level 3 (a
securities-fraud suit brought by
Pompliano and other shareholders of a
corporation alleged to have been
defrauded by Level 3) fell within the
"insured versus insured" exclusion in the

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policy; Pompliano had been a director of
one of Level 3’s subsidiaries, and as a
result was covered by Federal’s policy.
We held that Pompliano’s status did not
bar the entire claim by the insured, that
instead his share of the settlement in
the securities-fraud suit should be
subtracted and Level 3 thus entitled, in
the absence of other defenses by Federal,
to recover the rest of the settlement
from Federal under the D&O policy. Level
3 Communications, Inc. v. Federal Ins.
Co., 168 F.3d 956 (7th Cir. 1999). On
remand, the district court determined
that the amount of the settlement had
been $11.8 million, that it was a loss
within the meaning of the policy, that
$1.8 million of the settlement had gone
to Pompliano, and that Federal was
therefore liable to its insured, Level 3,
for $10 million.
Federal has appealed, arguing that the
settlement, though an outlay by the
insured, was not a "loss" within
themeaning of the insurance policy,
defined as "the total amount which any
Insured Person becomes legally obligated
to pay . . . including, but not limited
to . . . settlements," because the relief
sought in the suit against Level 3 was
restitutionary in nature. The plaintiffs
had sold shares in their corporation to
Level 3 and charged that they had done so
because of fraudulent representations
that Level 3 had made. In effect, Level 3
was accused of having obtained the
plaintiffs’ company by false pretenses;
and the plaintiffs’ suit sought to
rescind the transaction and recover their
shares, or rather the monetary value of
the shares because their company can no
longer be reconstituted. It’s as if,
Federal argues, Level 3 had stolen cash
from Pompliano and the other shareholders
and had been forced to return it and were
now asking the insurance company to pick
up the tab. Federal continues that a D&O
policy is designed to cover only losses
that injure the insured, not ones
thatresult from returning stolen
property, and that if such an insurance
policy did insure a thief against the
cost to him of disgorging the proceeds of
the theft it would be against public
policy and so would be unenforceable.
Mortenson v. National Union Fire Ins.
Co., 249 F.3d 667, 672 (7th Cir. 2001);
Bank of the West v. Superior Court, 833
P.2d 545, 554-55 (Cal. 1992); Central

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Dauphin School District v. American
Casualty Co., 426 A.2d 94, 96 (Pa. 1981).
This ground for dismissing Level 3’s suit
was raised by Federal in the initial
summary judgment proceedings, and it is
in retrospect unfortunate that the
district judge did not decide whether it
had merit, as that would have avoided the
need for two appeals to resolve Level 3’s
entire case.
The interpretive principle for which
Federal contends-- that a "loss" within
the meaning of an insurance contract does
not include the restoration of an ill-
gotten gain--is clearly right. Local 705
International Brotherhood of Teamsters
Health & Welfare Fund v. Five Star
Managers, L.L.C., 735 N.E.2d 679, 683
(Ill. App. 2000); Republic Western Ins.
Co. v. Spierer, Woodward, Willens, Denis
& Furstman, 68 F.3d 347, 351-52 (9th Cir.
1995); Reliance Group Holdings, Inc. v.
National Union Fire Ins. Co., 594
N.Y.S.2d 20, 24 (App. Div. 1993); Bank of
the West v. Superior Court, supra, 833
P.2d at 553; Central Dauphin School
District v. American Casualty Co., supra,
426 A.2d at 96; see also Chandler v.
Alabama Municipal Ins. Co., 585 So. 2d
1365, 1367 (Ala. 1991). The two cases on
which Level 3 relies, International Ins.
Co. v. Johns, 874 F.2d 1447, 1454-55
(11th Cir. 1989), and Limelight
Productions, Inc. v. Limelite Studios,
Inc., 60 F.3d 767, 769 (11th Cir. 1995),
are distinguishable, though Limelight
only tenuously. The facts were similar to
those in the present case, but the
operative term in the insurance policy
was "damages" rather than "loss," and so
was broader. In re Estate of Corriea, 719
A.2d 1234, 1240-41 (D.C. App. 1998), is
similar.
As the interpretive principle controls
this case, we need not consider the issue
of enforceability, though the two issues
are intertwined, since obviously an
insurance policy wouldn’t be presumed to
have been drafted in such a way as to
make it unenforceable. Cf. Central
Dauphin School District v. American
Casualty Co., supra, 426 A.2d at 96.
It is true, as Level 3 emphasizes, that
the plaintiffs in the underlying suit
were not seeking either the return of the
shares that Level 3 had allegedly winkled
them out of or the value of the shares on

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the date they were purchased. They were
seeking the difference between the value
of the stock at the time of trial and the
price they had received for the stock
from Level 3. That is standard damages
relief in a securities-fraud case. But it
is restitutionary in character. It seeks
to divest the defendant of the present
value of the property obtained by fraud,
minus the cost to the defendant of
obtaining the property. In other words,
it seeks to deprive the defendant of the
net benefit of the unlawful act, the
value of the unlawfully obtained stock
minus the cost to the defendant of
obtaining the stock. It is equivalent to
seeking to impress a constructive trust
on the property in favor of the rightful
owner. How the claim or judgment order or
settlement is worded is irrelevant. An
insured incurs no loss within the meaning
of the insurance contract by being
compelled to return property that it had
stolen, even if a more polite word than
"stolen" is used to characterize the
claim for the property’s return.
We can imagine situations in which there
would be a covered loss; this is
important as showing that the D&O policy
would not be rendered illusory by the
acceptance of Federal’s interpretation.
An example would be a fraudulent
statement by a corporate officer that
inflated the price of the corporation’s
stock without conferring any measurable
benefit on the corporation. Or suppose
that unbeknownst to Level 3 the officer
had stolen property for its benefit and,
not knowing this, Level 3 defended
against a suit seeking the return of the
property and incurred heavy legal
expenses in that defense. Those expenses
would be a loss to the company not offset
by any benefit to it, unlike the
"expense" that consists simply of the
value of the stolen property, a wash.
Safeway Stores, Inc. v. National Union
Fire Ins. Co., 64 F.3d 1282, 1286-87 (9th
Cir. 1995). All that the plaintiffs in
the underlying suit obtained was the
amount they received in settlement of
their claim against Level 3, and that
amount was part of Level 3’s gain from
its officers’ misbehavior. FTC v. Febre,
128 F.3d 530, 537 (7th Cir. 1997); Jordan
v. Duff & Phelps, Inc., 815 F.2d 429, 441
(7th Cir. 1987); SEC v. First City
Financial Corp., 890 F.2d 1215, 1230
(D.C. Cir. 1989); cf. Safeway Stores,

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Inc. v. National Union Fire Ins. Co.,
supra, 64 F.3d at 1286 and n. 8.
Level 3 acknowledges that if a judgment
had been entered in the suit against it
on the basis of a judicial determination
that it had engaged in fraud, Federal
would win; the policy so provides. It
couples this acknowledgment with the
inconsistent assertion that almost the
entire purpose of D&O policies is to
insure corporations and their officers
and directors against claims of fraud.
Pressed at argument concerning this
inconsistency, it argued that the line
runs between judgments and settlements.
As long as the case is settled before
entry of judgment, the insured is covered
regardless of the nature of the claim
against it. That can’t be right. Reliance
Group Holdings, Inc. v. National Union
Fire Ins. Co., supra, 594 N.Y.S.2d at 25
("determination of this appeal should not
hinge on the circumstance that Reliance
made restitution by way of settlement
instead of in satisfaction of a judgment
after trial"). It would mean, as Level
3’s lawyer confirmed at argument, that if
Level 3, seeing the handwriting on the
wall, had agreed to pay the plaintiffs in
the fraud suit all they were asking for
(a very large amount--almost $70
million), which they surely would not
have done had there been no evidence of
fraud (no rational defendant settles a
nuisance suit for the full amount
demanded in the complaint, unless the
amount is trivial), Federal would still
be obligated to reimburse Level 3 for
that amount. And that would enable Level
3 to retain the profit it had made from
a fraud. In fact Level 3 settled with the
plaintiffs in the fraud suit for the not
inconsiderable amount of $12 million
after the trial had begun and much of the
expense of defending the suit had
therefore already been incurred. It is
not surprising, therefore, that Level 3
has made no attempt to show that the
fraud suit was groundless and the
settlement merely an effort to avoid the
expense of defending a nuisance suit.
If Level 3 had shown that the fraud suit
was groundless, that there was no ill-
gotten gain that insurance would enable
it to keep, would the $12 million be a
"loss" within the meaning of the policy?
Federal argues no, that all that matters
is that the payment by the insured for

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which reimbursement is sought be in
respect of a claim of fraudulent
appropriation. Level 3 denies this. We
need not decide; and prudence is
definitely the better part of valor here,
since we can find no guidance on the
point from cases or other materials.
The judgment is reversed with
instructions to enter judgment for the
defendant.

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