Should the D&O Fraud Exclusion Have More Teeth?

The company’s stock price dropped substantially and shareholder plaintiffs have asserted numerous lawsuits against your company, the former CEO and CFO, and all independent directors–including you. Alleged damages far exceed D&O insurance limits, which have already been substantially reduced by defense costs.

When the SEC 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.

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.

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.

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.

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.

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, mitigating concerns from shared coverage.

John Tanner is vice president & 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.