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In a June 25, 2008 decision (here), the Delaware Superior Court (New Castle County) refused to apply a D&O policy adjudicated fraud exclusion to preclude coverage for the settlement, defense fees and costs incurred in connection with an underlying securities lawsuit.

The coverage action arose out of the AT&T Corporation Securities Litigation, the background regarding which can be found here. The case ultimately settled for $100 million. Prior to the settlement, the trial court granted the defendants’ motion for partial summary judgment, narrowing the case. The case went to trial on the remaining issues, but the parties reached a settlement before the jury reached a verdict. The court in the subsequent coverage litigation specifically noted that “there is no dispute that no court has held, and no jury has every found, that AT&T or any of the defendants in the Common Stock Litigation engaged in any deliberate, dishonest, fraudulent, or criminal act or omission.”

The primary policy in the applicable D&O insurance program provided in its base form that the insurer “shall not be liable to make any payment in connection with any Claim: brought about or contributed to in fact by any dishonest, fraudulent or criminal act or omission.” However, by Endorsement, this exclusion was deleted and replaced by language providing that he insurer is not obligated to pay any claim:

brought about or contributed to in fact by any deliberate dishonest, fraudulent or criminal act or omission, or any personal profit or advantage gained by any of the Directors and Officers to which they were not legally entitled and providing any such finding is material to the cause of action so adjudicated.

The primary carrier’s $20 million limit had been exhausted through payment of defense fees and costs. The first level excess carrier provided $25 million in “follow form” excess coverage. The excess carrier refused to pay either defense fees or contribute toward the settlement, claiming that the fraud exclusion bars coverage.

The Delaware court first turned to the question of what law to apply. The court ultimately determined that New York law governed. Interestingly, the basis of the court’s decision was language in the fourth level excess carrier’s policy. Because the court assumed that the parties’ intended that only one jurisdiction’s law would govern the entire program, the court found that the fourth level excess carrier’s language controlled even though the fourth level excess policy sits above the first level excess carrier’s policy.

The court then turned to the merits of the insurance coverage issue. The court paraphrased the exclusion as precluding coverage “for deliberate, dishonest, fraudulent, or criminal acts or omissions upon ‘such finding is material to the cause of action so adjudicated.’”

The court said that “no fact finder considered all the evidence and rendered a ‘finding” or verdict.” The court also observed that neither the summary judgment ruling nor the settlement adjudicated anything.

The court also specifically ruled that “the ‘adjudication’ contemplated in the policy does not, as [the excess insurer] asserts, mean an adjudication within the coverage dispute. It means an adjudication in the underlying action.” The court specifically noted that the excess insurer “cannot argue its way around” the change that the Endorsement introduced in the dishonesty exclusion wording. The court said the position argued by the excess carrier is “belied by the plain language of the policy.” The court added that “it is not a close question.” The court also observed that “to hold the fraud exclusion applicable” to a securities claim in the absence of an adjudication “would effectively eviscerate the purpose of the policy.”

The precise wording at issue in the AT&T coverage case is not typically used today. But the court’s analysis is nevertheless important as it pertains to the adjudication requirements for the typical adjudicated fraud exclusion that is found in many policies today. The court’s refusal to read into the clause a right by the insurer to adjudicate the issue of fraud in a separate coverage case amounts to a ruling that an adjudication fraud exclusion does not permit the fraud issue to be separately litigated, at least absent language to the contrary.

This is an important holding because while most contemporary D&O policies have an “adjudicated” fraud exclusion, there are also still some other policies that allow the insurer to litigate the fraud exclusion in a separate proceeding. The court’s holding in the AT&T case underscores the point that, without the separate proceeding language, the “”adjudication” referenced in the fraud exclusion pertains to the underlying proceeding, and the fraud exclusion therefore is inapplicable if there has been no fraud determination in the underlying proceeding.

The excess carrier’s inability to further litigate the fraud issue in the ATT&T coverage case also demonstrates the value to the policyholder of fraud exclusion language that does not permit separate adjudication. The presence of separate adjudication language potentially could have permitted the AT&T coverage litigation to go forward and potentially could have led to a finding that could have barred coverage. For that reason, a fraud exclusion that permits separate adjudication is undesirable from the policyholder’s standpoint. In the current insurance environment, most policyholders should be able to obtain adjudicated fraud exclusion language without any provision allowing separate adjudication.

A couple of final points about the decision. The first is that yet again a coverage dispute has arisen in which the excess carrier contested coverage after the primary carrier’s limits were exhausted. As I have frequently noted (most recently here), the D&O insurance industry continues to be challenged with issues arising as losses escalate through the insurance tower. The problem of excess insurer coverage disputes is an increasingly important issue that the industry must address.

Second, the court’s resolution of the question of the law to be applied to the first level excess carrier’s policy based on language in the fourth level excess carrier’s policy is interesting but at the same time potentially troublesome. The court’s reasoning seems practical and informed by a desire to reach a common sense solution; it is logical that only one jurisdiction’s law should apply to the entire tower.

The troublesome part is the court’s reference to upper layer policy provisions to resolve lower layer issues. The lower layer insurers often are unaware of provisions in the upper layer policies, and problems could emerge if the view were to develop that the meaning of lower layer policies can be discerned from language in upper layer policies. Maybe this concern reads too much into the court’s opinion, but the mere suggestion is troubling.


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