More Teeth for the D&O Fraud Exclusion

A D&O policy may require the insurer to continue advancing defense costs on behalf of “black hat”
co-defendants until there is a “final

adjudication” of wrongdoing.

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

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 chief executive and financial officers. The company’s stock price has dropped. Shareholder plaintiffs have sued 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 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 Securities and Exchange Commission 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.

Insurers seek modification

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 evidence required to invoke the “in fact” exclusion is not clarified. Whereas an insurer could not cite smoking gun evidence to deny coverage under an exclusion requiring a final adjudication, insurers can under “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 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 Insurance Co. v. Gross, 2005 WL 1048752 (E.D. Va. May 3, 2005) squarely frames the debate. The court required the D&O insurer to continue advancing defense costs to two former corporate insiders, despite their formal guilty pleas. Plaintiffs sued former officers and directors of Reciprocal of America for hiding the company’s financial condition from regulators, rating services and policyholders.

The insurer stopped reimbursing defense costs to those officers who pled guilty but continued advancing defense costs to other directors and officers. The fraud exclusion required a final adjudication that the individual in fact committed fraudulent 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 stop defense costs payments for those two defendants.

Policy review

There are lessons to learn from this. Review how a 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.

Finally, consider whether circumstances warrant purchasing dedicated insurance limits. Independent-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 vice president and claims counsel for the

Financial Services Division of insurance broker

McGriff, Seibels and Williams Inc., a wholly owned
subsidiary of BB&T. Phone (404) 847-1607 or e-

mail jtanner@mcgriff.com.

Topics Carriers Fraud