Should the D&O Fraud Exclusion Have More Teeth?

Imagine that you are a new independent director of a public company. Outside auditors uncovered accounting irregularities within one of the company’s primary sales divisions. An internal investigation 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 dropped substantially because of those events, 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 directors and officers insurance limits, which have already been substantially reduced by defense costs.

You read with interest of outside director settlements requiring personal contribution in the WorldCom and Enron cases, and are concerned that your company-and its indemnification obligations to you-may not survive the current crisis.

When the Securities and Exchange Commission and the Department of Justice initiated formal proceedings against the former CEO and CFO, both pled guilty to various criminal offenses including securities fraud, and admitted some of the fraudulent and criminal conduct alleged in the civil lawsuits.

You are pleased that justice has been served. Their conduct, after all, resulted in your being named in the lawsuits. You call your lawyer to vent: “At least my insurer can stop paying for those crooks’ attorney’s fees, right?”

Wrong.

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

In recent years, D&O insurers have alluded to similar fact patterns as justification for modifying their fraud exclusion wording. Preventing erosion of coverage by culpable parties is appealing. However, insureds should review their policy language to understand the circumstances under which their insurer may invoke the fraud exclusion to deny coverage or leverage a reduction in potential insurance payouts.

Some D&O policies require a “final adjudication” adverse to the insured before the exclusion is triggered. In that case, 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 in the face of 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 “in fact” wording.

Certain newer 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 necessarily limited to, guilty pleas). Under some variations of that “evidence of fraud” exclusion 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, No. Civ.A.305CV159, 2005 WL 1048752 (E.D. Va. May 3, 2005), squarely frames the ongoing debate. The district 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 as co-conspirators in an alleged scheme to hide ROA’s true financial condition from insurance department regulators, insurance rating services and policyholders. Two defendants, former officers, pled guilty to federal crimes including conspiracy to commit insurance fraud and mail fraud.

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

The next time you’re at the underwriting table to debate fraud exclusion wording:

• Review how your policy imputes conduct of individual insureds to the company, and determine the insurer’s rights under any allocation provisions. Invoking the fraud exclusion may result in a loss of coverage for the respective individual insured and the entity. 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.

• Review your company’s indemnification obligations to its former and current directors and officers. The indemnification and advancement obligations may be broader than the negotiated fraud exclusion trigger. Does your company have an obligation to advance defense costs under circumstances where the insurer may deny coverage?

Finally, consider whether your circumstances warrant purchasing dedicated insurance limits. Independent Director Liability policies or Side A-Only Difference-in-Conditions policies dedicated to certain specified 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.