Should the Directors and Officers Fraud Exclusion Have More Teeth?

Insureds need to understand the circumstances under which their insurer may invoke the fraud
exclusion to deny coverage or leverage a reduction

Imagine that you are a new independent director of a public company. Outside auditors uncovered accounting irregularities, which led to a restatement of financials, as well as to the firing of the company’s then CEO and CFO. The company’s stock price has dropped, and shareholder plaintiffs have asserted numerous lawsuits against the company, the former CEO and CFO, and all independent directors-including you. The alleged damages far exceed the total D&O insurance limits, which have already been substantially reduced by defense costs.

You read with interest about outside director settlements requiring personal contribution and are concerned that your company-and its indemnification obligations to you-may not survive.

When the SEC and the Department of Justice initiated formal proceedings, both former officers pled guilty to securities fraud and admitted some of the criminal conduct. Your insurer can now stop paying for those crooks’ attorney’s fees, right?

Wrong. A D&O policy may require an insurer to continue advancing defense costs on behalf of “black hat” co-defendants until there is a “final adjudication” of wrongdoing in the civil lawsuit.

Recently, D&O insurers have alluded to similar fact patterns as justification for modifying their fraud exclusion wording. Insureds thus need to understand the circumstances under which their insurer may invoke the fraud exclusion to deny coverage or leverage a reduction in potential payouts.

Some D&O policies require a “final adjudication” adverse to the insured before the exclusion is triggered. So insurers may be unable to invoke the exclusion in a settlement context. Because most securities claims are settled short of a final adjudication, such wording rarely allows the insurer to deny coverage, even with smoking gun evidence of deliberately fraudulent acts by individual insureds.

Other policies require only that the requisite conduct occurred “in fact.” The degree of evidence required to invoke the “in fact” fraud exclusion is not clarified; nor is the issue of whether an adjudication is necessary. Whereas an insurer could not point to smoking gun evidence and deny coverage in good faith in the face of an exclusion expressly requiring a final adjudication of fraud, insurers can under such “in fact” wording.

Certain new policy forms trigger the exclusion where the conduct occurs “in fact,” as evidenced by an insured’s written statements, documents or admissions (including, but not limited to, guilty pleas). Under variations of this “evidence of fraud” wording, the insurer may deny coverage by pointing to deposition testimony by any insured that another insured committed fraud. Other variations permit the insurer to deny coverage upon a final determination in a parallel coverage lawsuit or alternative dispute resolution proceeding.

Great American Ins. Co. v. Gross, 2005 WL 1048752 (E.D. Va. May 3, 2005), squarely frames the ongoing debate. In that case, the court granted a preliminary injunction requiring the D&O insurer to continue advancing defense costs to two former corporate insiders-despite formal guilty pleas. Plaintiffs sued former officers and directors of Reciprocal of America for hiding the company’s financial condition from insurance department regulators, rating services and policyholders. The former officers pled guilty to federal crimes, including conspiracy to commit insurance and mail fraud.

The insurer stopped reimbursing defense costs to those officers but continued advancing defense costs to other directors and officers named in the lawsuits. The fraud exclusion required a final adjudication that the individual insured in fact committed fraudulent, dishonest or criminal acts, which brought about or contributed to the claims. Because the court had not yet decided whether fraudulent conduct by the “black hat” defendants “contributed to” or “brought about” the lawsuits, the guilty pleas did not permit the insurer to stop advancing defense costs to those two defendants.

Carefully review how your policy imputes conduct of individual insureds to the company, and determine the insurer’s rights. The individual insured and the entity may lose coverage if the fraud exclusion is invoked. Where the fraud exclusion applies to eliminate coverage for a culpable individual insured and the company, the insurer may be able to allocate most of any remaining “loss” to non-covered insureds or matters.

Also review the company’s indemnification obligations to its former and current directors and officers. Those obligations may be broader than the negotiated fraud exclusion trigger. Is your company obliged to advance defenses costs under circumstances where the insurer may deny coverage?

Finally, consider whether circumstances warrant purchasing dedicated insurance limits. Inde-pendent Director Liability policies or Side A-Only Difference-in-Conditions policies dedicated to certain insureds (such as audit committee members only, or outside directors only) provide coverage for a smaller group of individuals, thereby mitigating concerns that can arise from shared coverage.

John Tanner is with insurance broker McGriff, Seibels
and Williams Inc. Phone: (404) 847-1607.