Specialty Lines Advisory (Vol. 7, No. 9, November 2011)

Click here to view the PDF version of the November 1, 2011 Edition of the Specialty Lines Advisory

Parent Corporations With “Ultimate Authority” are Potentially Liable for Alleged Misrepresentations Made by Subsidiary in Registration Statement
Authored by:
Ryan Taylor, Associate in the Chicago Office

A motion to dismiss a securities shareholder class action complaint was recently denied in part by the Southern District of New York because the plaintiffs sufficiently alleged that a defendant parent corporation had “ultimate authority” and liability for alleged false statements made in a registration statement issued by its subsidiary. City of Roseville Employees’ Retirement System v. EnergySolutions, No. 09 Civ. 8633, 2011 WL 4527328 (S.D.N.Y. Sept. 30, 2011). In doing so, the Court distinguished the United States Supreme Court’s decision in Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011), which held that only the actual “maker” of a statement may be liable under Section 10(b) of the Securities Exchange Act and Rule 10b-5.

The case stems from a securities class action brought by shareholders against EnergySolutions, Inc. (“ES”), a company that provides services to nuclear power plants, and its parent corporation, ENV Holdings (“ENV”), relative to the initial public offering of ES. The complaint alleged claims for violations of Sections 10(b), 11, 12(a)(2), 15, and 20 of the Securities Exchange Act and Rule 10b-5. According to the complaint, the Registration Statements filed by ES contained false or misleading statements, or omitted material facts relating to the company’s financial opportunities in the nuclear reactor market and potential regulatory restrictions.

Defendants moved to dismiss all claims, including ENV, based on the holding in the Janus case wherein the Supreme Court expressly held that only the actual “maker” of a statement may be held liable under Rule 10b-5. According to the Court in Janus, for purposes of Rule 10b-5, a party can be liable for “making” a false statement only if the party is “the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it. Without control, a person or entity can merely suggest what to say, not ‘make’ a statement in its own right. One who prepares or publishes a statement on behalf of another is not its maker.” Accordingly, under Janus a party that only assists in the “making” of a misstatement cannot be held liable.

While the Court granted the motion to dismiss as to certain alleged misrepresentations, it was denied with respect to all material allegations. In doing so, the Court created a significant distinction from Janus by adopting a standard under which a parent corporation with “ultimately authority” over a statement is potentially liable for “making” a misleading public statement even if made by a separate and distinct legal entity. In distinguishing Janus, the Court in Roseville relied on the Registration Statements, which revealed that a.) ENV was the sole owner of stock of ES at the time of the initial public offering; b.) ES was wholly owned by ENV; c.) ENV would retain a controlling interest in ES after the initial public offering; and d.) ENV had authority to determine when and whether to sell the shares being sold.

According to the Court, unlike Janus the Registration Statements in Roseville contained so many indicia of control of ENV over ES that ENV’s role went well beyond that of “a speechwriter drafting a speech” because ENV had control over the content of the message, the underlying subject matter of the message, and the ultimate decision of whether to communicate the message.

Tressler Comments:  Not only is the Roseville Court’s ruling notable because it is one of the first district court applications of the Janus decision, it is also significant in its discussion of both when and why parties may be liable for the alleged misrepresentations of another party. In expanding the scope of who can be held liable, the Court in Roseville focused on the degree of control exercised over the party actually “making” the statement.

Two Pleadings Contain “Interrelated Wrongful Acts” Despite the Inclusion of New Parties and Causes of Action in the Amended Complaint
Authored by:
Monica Mendes, Associate in the Los Angeles Office

A directors and officers liability insurance policy’s definition of “Interrelated Wrongful Acts” included both an original cross-complaint and the first amended cross-complaint despite the fact that the amended pleading asserted new causes of action and added new cross-defendants. Feldman v. Illinois Union Insurance Co., 2011 Cal. App. LEXIS 116 (Cal. Ct. App. Sept. 6, 2011) 

In this case, the underlying lawsuit was filed by ZF Micro Solutions, Inc. (“ZF Solutions”) against National Semiconductor Corporation (“NSC”) on April 25, 2002. On May 28, 2002, NSC filed a cross-complaint against both ZF Micro Devices, Inc. (“ZF Devices”) and ZF Solutions, which was the successor to ZF Devices. One year later, on April 25, 2003, NSC filed a first amended cross-complaint, which added David Feldman, the president and chief executive officer of ZF Solutions, and two other cross-defendants and also asserted new causes of action against the cross-defendants.

Illinois Union Insurance Company (“Illinois Union”) issued a policy that provided coverage for ZF Solutions and its directors from July 1, 2002, to July 1, 2003. Feldman tendered the defense of NSC’s amended cross-complaint to Illinois Union, but Illinois Union denied coverage on the grounds that NSC’s claim had originally been made on May 28, 2002, which was prior to the inception of the Illinois Union policy. Id. As a result, ZF Solutions, ZF Devices, and Feldman subsequently filed suit against Illinois Union regarding its obligations under the policy.

The Illinois Union policy provided that “[m]ore than one Claim involving the same Wrongful Act or Interrelated Wrongful Act shall be deemed to constitute a single Claim and shall be deemed to have been made at the earliest of the following times: (a) the time at which the earliest Claim involving the same Wrongful Act or Interrelated Wrongful Act is first made . . . .” Additionally, the policy defined “Interrelated Wrongful Acts” as “more than one Wrongful Act which have as a common nexus any fact, circumstance, situation, event or transaction or series of facts, circumstances, situations, events or transactions.” The issue before the court was whether NSC’s claims involved “Interrelated Wrongful Acts” such that NSC’s first amended cross-complaint would be deemed to have been made at the time NSC filed its original cross-complaint, which was before the Illinois Union policy incepted.

In its analysis, the court examined and compared the allegations within NSC’s original cross-complaint with the allegations in the amended cross-complaint. Notably, while the original cross-complaint only included two causes of action – breach of contract and successor liability – the amended cross-complaint expanded NSC’s theories of recovery and also added Feldman and two other cross-defendants. Specifically, while the amended cross-complaint again alleged that the “fraudulent transfer” of ZF Devices’ assets to Feldman and ZF Solutions, via the purported foreclosure and assignment to the Kennedy Trust, was made to “hinder, delay or defraud” creditors, including NSC, the amended cross-complaint also added causes of action for fraudulent conveyance and conspiracy, violations of Business and Professions Code Section 17200, breach of fiduciary duty, and invasion of privacy.

Despite the addition of new defendants and causes of action, the court concluded that based on its comparison of the two pleadings, while the amended cross-complaint included many new details of the events contributing to the alleged liability of the cross-defendants, all of those details pertained to the alleged fraudulent assignment and transfer of ZF Devices’ assets to ZF Solutions, made with the intent of avoiding the company’s obligation to NSC. Accordingly, the court found that while the amended cross-complaint expanded NSC’s theories of recovery, “three of the four new causes of action asserted against Feldman . . . had ‘as a common nexus any fact, circumstance, situation, event or transaction or series of facts, circumstances, situations, events or transactions’ in relation to the original cross-complaint.” The court therefore concluded that these claims constituted a single claim, which was originally made in April 2002, before the inception of the Illinois Union policy; thus, Illinois Union did not have a duty to defend NSC’s cross-complaint.

The court did note, however, that the fifth cause of action for invasion of privacy “arguably pertained to a different set of circumstances.” However, the court did not definitively address this issue since the Illinois Union policy contained an exclusion which precluded coverage for illegally recorded conversations (the subject of the invasion of privacy cause of action), and thus, there was no duty to defend NSC’s cross-complaint.

Tressler Comments:  This case serves as another illustration of how California courts are inclined to relate claims. Specifically, the Feldman court broadly interpreted the meaning of the phrase “common nexus any fact, circumstance, situation, transaction . . .” within the policy’s definition of “Interrelated Wrongful Acts.” In particular, while the amended cross-complaint added new defendants and causes of action, the court refused to focus on those factors in determining whether the claims constituted “Interrelated Wrongful Acts.” Rather, the court focused on the fact that both cross-complaints stemmed from the same alleged fraudulent conveyance, which was designed to avoid the former company’s obligations to NSC.

Accordingly, to the extent a professional liability policy includes an “interrelated wrongful act” definition similar to that within the Illinois Union policy, we can expect the California courts to broadly interpret that definition to encompass all claims that derive from the same set of facts, circumstances, situations or transactions.

Excess Policies Not Triggered Unless Full Limits of Underlying Coverage Are Actually Paid
Authored by: 
William Rusteen, Associate in the Los Angeles Office

In Citigroup, Inc. v. Federal Insurance Company, No. 10-20445, 2011 U.S. App. LEXIS 16316 (5th Cir. Aug. 5, 2011), the Fifth Circuit concluded that, where the plain language of an excess policy requires complete exhaustion of an underlying policy, excess coverage is not triggered until the limits of the underlying coverage have been paid in full by the underlying insurer.  

Two lawsuits were filed against Associates First Capital Corporation (“Associates”), a lender acquired by Citigroup, Inc. (“Citigroup”). Prior to its acquisition, Associates obtained $200 million of coverage from various insurers at three different levels. Lloyd’s of London (“Lloyd’s”) provided primary coverage of $50 million. The second layer of coverage provided another $50 million, while the third layer provided $100 million (collectively the “excess insurers”).

After Citigroup settled both lawsuits, each insurer denied coverage. Eventually, Lloyd’s paid $15 million in exchange for a release for the two underlying lawsuits. However, the excess insurers continued to deny coverage, and Citigroup initiated a lawsuit to determine whether the excess insurers were obligated to provide coverage.

Citigroup asserted that each excess insurers’ policy language was ambiguous and argued that the decision in Zeig v. Massachusetts Bonding & Insurance Co., 23 F. 2d 665 (2d Cir. 1928), therefore should be applied. Zeig held that when the “exhaustion” language is ambiguously defined in an excess policy, a settlement with a primary insurer constitutes an “exhaustion” of the primary policy, even when the full limits have not been paid by the primary insurer. The Fifth Circuit rejected Citigroup’s argument that Zeig should be applied, finding that the excess policies were not ambiguous and finding that excess policies required, by their plain language, that the primary insurer pay out the full limits before the excess policies could be triggered. The Fifth Circuit relied on the following policy provisions:

• Federal Insurance Company’s policy provided coverage after “(a) all Underlying Insurance carriers have paid in cash the full amount of their respective liabilities, (b) the full amount of the Underlying Insurance policies have been collected by the plaintiffs, the Insureds or the Insureds’ counsel, and (c) all Underlying Insurance has been exhausted.”
• St. Paul Mercury Insurance Company’s policy provided coverage only “after the total amount of the Underlying Limit of Liability has been paid in legal currency by the insurers of the Underlying Insurance as covered loss thereunder.”
• SR International Business Insurance Company’s policy provided coverage “only after any Insurer subscribing to any Underlying Policy shall have agreed to pay or have been held liable to pay the full amount of its respective limits as set forth in Item 5. of the Declarations.”
• Steadfast Insurance Company’s policy attached “[i]n the event of the exhaustion of all the limit(s) of liability of such ‘Underlying Insurance’ solely as a result of payment of loss thereunder.”

The Fifth Circuit held that the phrase “full amount” found in the Federal and SR policies meant that a settlement for less than the full limits of the primary coverage did not trigger the excess policies. The court also found that the use of “total” limit of liability in the St. Paul policy required the primary insurer to actually pay the full $50 million limit before the St. Paul policy could be triggered. Finally, the requirement in Steadfast’s policy of exhaustion of “all” primary limits meant that settlement for less than $50 million did not trigger Steadfast’s coverage. Additionally, Steadfast’s use of “payment of loss” required the primary insurer to actually pay the $50 million limit to the insured in order to exhaust the coverage.

Tressler Comments:  While the Fifth Circuit concluded that the language of the excess policies was unambiguous and had to be enforced as written, the excess insurers may have been obligated to provide coverage, even though the insured had settled with the primary insurer for less than the full limits, had the court found the language to be ambiguous. Even if the court had found the policy language to be ambiguous, the attachment point of the excess insurers would not have changed. The insured, not the excess insurers, would have been required to fill the gap between the amount of the primary limits and the amount actually paid by the primary insurer.

“Prior Knowledge Provision” Triggered When a “Reasonable Person” Would Have the Belief That a Claim Could Be Made
Authored by:
Elizabeth McGarry, Associate in the Chicago Office

In determining whether, under employment practices liability coverage, a Prior Knowledge provision operated to preclude coverage, the United States District Court for the Western District of Missouri adopted an objective standard holding that the provision applies if a reasonable person would believe a claim could be made given the facts, circumstances or situation. First Bancshares v. St. Paul Mercury Insurance Company, 2011 U.S. Dist. LEXIS 105405 (W.D. Mo. Sept. 16, 2011).

St. Paul Mercury Insurance Company issued an insurance policy to First Bancshares, Inc. First Homes Savings Bank, a subsidiary of First Bancshares was an insured under the policy. The policy insured First Bancshares and First Homes (“Insureds”) against any claim of an “Employment Practices Act”, which included claims of wrongful discharge by former employees. Coverage under the policy did not extend to claims arising from facts or circumstances of which the Insureds were aware prior to the issuance of the policy. The Insureds were asked to report all facts that could reasonably give raise to a claim against them. Coverage under the policy was effective July 1, 2007, through July 1, 2010.

Vicky Dooms, an employee of First Homes, was terminated on April 12, 2007. On April 29, 2007, Dooms filed an application for unemployment benefits with the Missouri Division of Employment Security (“Division”). Dooms lost on her initial application, filed an appeal on May 21, 2007 (which she also lost), and subsequently filed suit against the Insureds on October 4, 2009, alleging wrongful discharge.

The Insureds tendered the matter to St. Paul and St. Paul declined coverage. The Insureds filed suit against St. Paul seeking a finding that the subject policy applied to Dooms’ claim. St. Paul moved for summary judgment on the basis that, under the terms of the Prior Knowledge provision of the policy, Dooms’ wrongful discharge claim was not covered. The Prior Knowledge provision provided that “any claim arising from any such fact, circumstance, or situation to the extent the claim is against an Insured who knew of such fact, circumstance or situation prior to issuance of the proposed policy” was not covered. The provision described “prior knowledge” as “any knowledge or information of any fact, circumstance or situation related to any coverage that is available under this policy which could reasonably give rise to a claim against [the Insureds].”

St. Paul argued that a determination of whether the proceedings before the Division satisfied the Prior Knowledge provision consisted of two elements: (1) whether the Insureds knew of facts, circumstances or situations which could reasonably give rise to claim; and (2) whether Dooms’ suit against the Insureds arose from facts, circumstances or situations known to them. St. Paul asserted that the proceedings before the Division constituted prior knowledge because in Dooms’ application for unemployment benefits she claimed she was retaliated against from being a “whistleblower” with respect to two officers she alleged engaged in unethical conduct.

The Insureds did not dispute that Dooms’ lawsuit arose from facts, circumstances or situations encompassing the proceedings before the Division, and did not dispute that they were aware of the proceedings. The issue before the court was whether the Division proceedings encompassed facts, circumstances or situations that could have reasonably given rise to the claim. The Insureds argued that the proceedings did not meet the requirements of the Prior Knowledge provision because (1) the proceedings were resolved in their favor; and (2) Dooms never made a threat of lawsuit after the proceedings concluded and before suit was filed.

St. Paul argued that a “reasonable person” standard should control the determination of whether the proceedings before the Division satisfied the Prior Knowledge provision requirements. The court agreed, citing to a Missouri Supreme Court decision which upheld a determination that a law firm sued for malpractice was not covered under its malpractice insurance policy that provided coverage for acts occurring before the policy period as long as the firm had no basis for believing that it had committed an act subjecting it to liability. See Wittner, Poger, Rosenblum & Spewak v. Bar Plan Mut. Ins., Co., 969 S.W.2d 749, 754 (Mo. 1998). In Wittner, the Supreme Court concluded that there was a basis to believe the law firm committed an act subjecting itself to liability where a default decree was entered against its client and the client complained of the decree and indicated that she would file suit.

The Court in First Bancshares similarly held that, from an objective perspective, the facts, circumstances or situations surrounding the proceedings in the Division could reasonably give rise to claim. Although the proceedings before the Division ended in a determination in the Insureds’ favor, the basis for the proceedings was Dooms’ termination. Throughout the proceedings Dooms claimed she was terminated as retaliation (the same basis for her state court action). Moreover, even though there was no evidence to suggest that Dooms directly threatened the Insureds with suit, the nature of her allegations during the proceedings could reasonably give rise to claim. The court found that knowledge of the proceedings before the Division was sufficient to satisfy the Prior Knowledge provision excluding coverage under the policy.

Tressler Comments:  The decision reached in First Bancshares is significant in that it highlights the broader standard adopted by some jurisdictions with respect to the application of a Prior Knowledge provision or exclusion. While some courts focus solely on a “subjective standard” (i.e. the insured’s actual belief that a claim will be made as opposed to a “reasonable person’s” belief that a claim could be made), and some focus on a hybrid subjective/objective standard, the standard adopted by the District Court appears to be more favorable for insurers. Under such an objective standard, an insured may be required to report any facts that could give rise to a claim, even if there is no evidence to indicate that such a claim will actually be made in the future, if a reasonable insured would have concluded that the circumstances could give rise to a claim.

When determining whether a Prior Knowledge provision may apply to a certain claim or lawsuit, insurers should be cognizant of the standard (objective v. subjective) applied by courts in the subject jurisdiction.

No Coverage for an EEOC “Claim” When Policy Requires that “Suits” Be Brought By an Employee
Authored by:
Elizabeth Musser, Associate in the Los Angeles Office

The Middle District of Tennessee finds that no coverage is available for a discrimination claim filed against the insured by the EEOC, because the applicable policies provide coverage only for suits brought by an “employee.” Cracker Barrel Old Country Store, Inc. v. Cincinnati Ins. Co., Case No. 3:07-cv-00303 (Sept. 21, 2011 M.D. Tenn.). 

Cincinnati Insurance Company issued consecutive insurance policies to Cracker Barrel Old Country Store, Inc., which provided coverage for employment practices liability during the period June 1, 2000, to August 1, 2004 (the “EPL Policies”). Under each of the EPL Policies, Cincinnati agreed to defend and indemnify Cracker Barrel in connection with “claims” made during the policy period. Each of the EPL Policies defines “claim” as a “civil, administrative or arbitration proceeding commenced by service of a complaint or charge, which is brought by any past, present or prospective employee.” A “claim” must also assert a cause of action for one of various wrongful employment practices, including wrongful termination and sexual harassment.

Between December 1999 and March 2001, 10 Cracker Barrel employees filed sexual and racial discrimination claims against Cracker Barrel with the Illinois Department of Human Rights and the U.S. Equal Employment Opportunity Commission (“EEOC”). On July 29, 2004, Cracker Barrel notified Cincinnati of the pending claims. The EEOC filed suit against Cracker Barrel on August 11, 2004, asserting claims for violation of Title VII to the Civil Rights Act of 1964 (which generally prohibits employment discrimination on the basis of gender, race, or religion), and violation of Title I to the Civil Rights Act of 1991 (which governs remedies in the event of intentional employment discrimination).

The EEOC served its complaint on Cracker Barrel on September 19, 2004, but Cracker Barrel did not provide Cincinnati with written notice of the suit until July 22, 2005. The court’s order does not provide any insight as to this apparent delay in providing notice. In any event, Cincinnati disclaimed coverage, presumably in response to the initial notice of claim on July 2004, as well as in response to the complaint in July 2005. Following settlement negotiations between Cracker Barrel and the EEOC, the parties entered into a consent decree, whereby Cracker Barrel agreed to establish a $2 million settlement fund. Prior to settlement, Cracker Barrel incurred about $700,000 in defense fees and costs.

Cracker Barrel filed the instant action in March 2007 against Cincinnati, seeking reimbursement of defense fees and costs incurred in defending the EEOC’s suit, as well as indemnification for the
$2 million settlement fund.

The parties filed cross-motions for summary judgment. The court applied Tennessee law, which does not permit consideration of extrinsic evidence outside the “four corners” of the complaint. Argument focused on the definition of “claim” in the EPL Policies, which as set forth above is a “civil, administrative or arbitration proceeding commenced by service of a complaint or charge, which is brought by any past, present or prospective employee.” Cincinnati argued that the EEOC’s suit is not a “claim” under the EPL Policies’ definition, because suit was brought by the EEOC, not by “any past, present or prospective employee.” Cracker Barrel argued that the EEOC’s suit is a “claim,” because it asserts the type of wrongful employment practices that the parties contemplated would be covered under the EPL Policies. Cracker Barrel took the position that the “employee” requirement modifies “complaint or charge” (applying the standard “last antecedent rule” of grammar, whereby a phrase after a comma modifies the noun or phrase it immediately follows), and that there was no requirement that the employee actually file suit. Neither party cited any law supporting its interpretation of the EPL Policies’ definition of “claim.”

The court granted Cincinnati’s summary judgment motion, and denied Cracker Barrel’s summary judgment motion. The court agreed with Cincinnati that the EPL Policies apply only to suits brought by employees, and that there was no duty to defend or indemnify Cracker Barrel in connection with a suit brought by the EEOC, a non-employee. The court agreed that Cracker Barrel correctly identified the grammatical rule at issue, but stated that it would not rigidly apply such a rule where it appeared evident that the parties did not intend for suits brought by non-employees to be covered. The court noted that the parties could have chosen to agree on a definition of “claim” that expressly included suits arising out of any charges or complaints filed by employees, or that expressly included suits brought by the EEOC.

Tressler Comments:  The court’s ruling in this action is rather surprising. Wrongful employment practices claims are frequently brought as administrative claims by employees in the first instance, and then actually litigated by the EEOC or another federal or state agency, which seeks damages on behalf of the employees. Given the court’s acknowledgement that a strict grammatical interpretation of the definition of “claim” would result in coverage, we would have expected the court to apply this analysis, and find that coverage was owed. We anticipate that Cracker Barrel will appeal this decision to the Sixth Circuit, and will be interested in reviewing any opinion that may result.

Organization Insurance Carriers Owed No Coverage to Office Depot for Pre-Claim Legal Expenses
Authored by:
Devin Maddox, Associate in the Chicago Office

Office Depot sought coverage from its Organization Insurance carriers for legal costs incurred in connection with the SEC’s preliminary inquiries and investigation into whether Office Depot violated securities laws. The court ruled that such inquiries and investigation did not constitute a Securities Claim or Claim under the policies because they did not allege violations or identify specific individuals against whom charges might be brought in the future, and therefore were insufficient to trigger coverage. Office Depot, Inc. v. National Union Fire Insurance Co. of Pittsburgh, PA, et al., No. 11-10814, 2011 U.S. App. LEXIS 20759 (11th Cir. October 13, 2011).

Office Depot incurred more than $20 million in legal fees in connection with responding to inquiries and investigations of the Securities and Exchange Commission. Specifically, after an article on the Dow Jones Newswire reported that Office Depot may have violated federal securities laws by selectively disclosing nonpublic information, the SEC notified Office Depot that it would be conducting an inquiry to determine whether Office Depot had violated any securities laws. Subsequently, the SEC asked Office Depot to produce certain documents in furtherance of the inquiry, and later issued subpoenas to various officers and directors and “Wells Notices” recommending that civil action be taken against three officers. Ultimately, two years after sending its initial inquiry letter to Office Depot, the SEC filed a formal complaint against Office Depot.

Office Depot sought coverage from National Union Fire Insurance Company and American Casualty Company (collectively the “insurers”) under the insurers’ respective policies for all legal costs incurred after Office Depot received its first SEC letter on the basis that such costs constituted Defense Costs under the insurers’ policies. After the insurers denied coverage, Office Depot filed a declaratory judgment action against the insurers in the U.S. District Court for the Southern District of Florida. The District Court granted summary judgment in favor of the insurers and against Office Depot on grounds that, pursuant to Florida law, the majority of the legal fees at issue were not covered under the policies. Office Depot appealed to the 11th Circuit U.S. Court of Appeals.

On appeal, Office Depot argued that the lower court erred for several reasons, including, but not limited to, the following: (1) the SEC’s initial letter to Office Depot constituted a Securities Claim as that term was defined in the policies and therefore triggered the insurers’ coverage obligations; (2) the policy’s definition of a Claim did not include a temporal limitation barring coverage for costs of investigating an anticipated claim or actual claim; and (3) that the Notice/Claim Reporting Provisions of the policies allowed recovery of Defense Costs incurred following Office Depot’s submission of a notice of circumstances that may lead to Claim, which it sent to the insurers immediately after the Dow Jones article was published.

The court rejected each of Office Depot’s contentions. First, the court looked to the section of the policy providing coverage for Losses arising from “Securities Claims.” Securities Claim was defined to include “a Claim, other than an administrative or regulatory proceeding against, or investigation of an Organization, made against the Insured.” The definition, however, further stated that “[n]otwithstanding the foregoing, the term ‘Securities Claim’ shall include an administrative or regulatory proceeding against an Organization” under certain circumstances. The court opined that, while this definition contained a “carve-back” provision restoring coverage for administrative or regulatory proceedings in particular situations, it clearly did not restore coverage for administrative or regulatory investigations of Office Depot. As the SEC’s initial letters requesting Office Depot’s voluntary cooperation and discovery requests served pre-suit constituted an “investigation,” and not an “administrative or regulatory proceeding, the court held that Office Depot’s legal expenses incurred in connection with such investigation were not covered under the policies.

Next, the court addressed Office Depot’s assertion that the policies’ definition of Defense Costs did not expressly exclude pre-Claim expenses. The policy defined Defense Costs as “reasonable and necessary fees, costs, and expenses consented to by the Insurer … resulting solely from the investigation, adjustment, defense and/or appeal of a Claim against an Insured….” The court opined that this definition unambiguously limited Defense Costs to those costs incurred after a Claim had been made as “investigation of a Claim necessitates that a Claim exists to investigate.”

A Claim was defined in the policy to include a civil, criminal, administrative, or regulatory investigation of an Insured Person: (1) once such person was identified in writing by such investigating authority as a person against whom a proceeding may be commenced; or (2) in the case of an investigation by the SEC, after the service of a subpoena upon such Insured Person. The early letters from the SEC to Office Depot merely asked Office Depot to preserve certain documents and requested that several individuals provide testimony. Unlike the Wells Notices and formal subpoenas that were later sent by the SEC to Office Depot, the early letters did not allege specific violations or identify specific individuals who could be charged in future proceedings or formally demand information. Hence, the court ruled that legal costs incurred in connection with the SEC’s investigation prior to Office Depot’s receipt of the Wells Notices and formal subpoena were not incurred after a Claim was made and therefore were not covered under the policies.

Lastly, the court considered the policies’ “Notice/Claim Reporting Provisions,” which required, in part, Office Depot to give written notice of circumstances that may reasonably be expected to give rise to a Claim. The provisions further provided that a Claim subsequently made against Office Depot alleging, arising out of, based upon, or attributable to such circumstances would be considered made at the time such notice of such circumstances was given. Office Depot claimed that this language allowed SEC’s formal claims to “relate back” to the date Office Depot submitted its notice of circumstances (upon receipt of the Dow Jones article) such that any costs incurred between the notice and the date SEC filed its claims were covered under the policies. The court disagreed, holding that the purpose of the policies’ reporting provisions was to provide a notification process for Claims filed both inside and outside the policy period. Thus, the provisions solely determined the policy period that Claims would be “considered made,” and did not expand coverage to costs incurred before a Claim was actually made. Accordingly, the court affirmed the district court’s decision.

Tressler Comments:  Notably, the court did not hold that coverage was precluded for all legal costs incurred prior to the filing of the SEC’s formal complaint against Office Depot. To the contrary, the court acknowledged that the SEC’s Wells Notices, recommending the commencement of a lawsuit against officers of Office Depot, and formal subpoena were sufficient to constitute a Claim under the policies. Hence, when considering SEC-related claims against an insured, professional liability carriers with similar policy language as that considered in Office Depot must not look solely to the SEC complaint, but rather to the nature of the communications between the SEC and the insured to determine when their coverage obligations, if any, arise.

Excess D&O Insurers Avert “Drop Down” in Southern District of New York Decision
Authored by:
Jill A. Ellman, Associate in the New York Office

In Federal Insurance Company v. The Estate of Irving Gould, et al., Case No. 10-cv-01160 (S.D.N.Y. Sept. 28, 2011), Judge Richard Sullivan ruled on separate motions, brought by excess insurers and by their insureds, concerning the obligation of excess insurance policies to “drop down” to fill gaps left by insolvent insurers. Judge Sullivan granted excess insurers’ motions for judgment on the pleadings that their policies did not “drop down” in the event of underlying insurer insolvency. Judge Sullivan also denied the insureds’ partial summary judgment seeking a declaration that excess insurers’ coverage obligations commenced once defendants’ losses exceeded the limit of any of the underlying policies.

Commodore International Limited (“Commodore”) purchased a $51 million directors and officers insurance tower with nine different policies, including two policies issued by Federal Insurance Company (“Federal”), one by Travelers Casualty and Surety Company (“Travelers”)(collectively, the “Excess Insurers”), as well as those issued by underlying and eventually bankrupt insurers (Reliance Insurance Company and Home Insurance Company).¹ As follow form policies, the Federal and Travelers policies (collectively, the “Excess Policies”) were obligated to advance defense costs once their policies are triggered. The Excess Policies also contained provisions regarding the “Maintenance of Underlying Insurance.”² Commodore’s directors and officers were named in an assortment of lawsuits, all of which were resolved, except an action in the Supreme Court of the Commonwealth of the Bahamas with purported claims of $100 million. The insureds incurred approximately $14 million in defense costs, exceeding the $10 million in limits already paid out by the primary insurer, now known as Chartis Insurance Company of Canada. Federal commenced a declaratory action seeking a judgment that the Excess Policies issued to Commodore have not been triggered.

The Excess Insurers moved for a judgment absolving their insurance policies from dropping down to cover the gaps of the insolvent insurers. The defendants argued that because the Excess Policies did not specifically provide “anti drop-down” language in their policies, as it appeared in policies issued to other insureds, more discovery was needed to determine the intent of the language in the Excess Policies. Judge Sullivan found no such ambiguity. He interpreted the policy language “[the insurer] shall not be liable to a greater extent than if this condition had been complied with” to mean that the Excess Policies shall not be broadened to incorporate drop-down coverage to fill the gaps of underlying insolvent insurers. The court found that the Excess Insurers were therefore not obligated to provide coverage.

Next, the court considered the issue presented by the insureds in their motion for partial summary judgment of whether the Excess Insurers’ coverage obligations are triggered in the event that the insureds’ incurred losses exceed the underlying policy limits, even if such losses are prospective. Judge Sullivan found that the motion was ripe for adjudication because substantial controversy, the issue of when the Excess Policies were triggered, and immediacy of that controversy, the impending litigation in the Bahamas with damages of up to $100 million, had been met.

The court found that the Excess Policies’ language set a condition precedent to their attachment, “the excess coverage is not triggered until the underlying insurance is exhausted ‘solely as a result of payment of losses thereunder.’” In other words, the Excess Policies would not attach until payment was made by the underlying policies. The court rejected cases relied upon by the insureds, namely Koppers and Zeig,³ as the facts of those cases differed from the current case. “[I]n those cases the insured agreed to accept partial reimbursement for his losses while maintaining responsibility for the uncompensated portion of his claim…[which] is in contrast to Defendants’ reading of the Excess Policies, pursuant to which the liability covered by the insolvent insurers would not be discharged by any payment or settlement, but would simply be bypassed,” the court said.

Judge Sullivan further surmised that inflated settlements might likely result in the event that the defendants are able to trigger excess policies simply based on their losses. Referencing Zeig, Judge Sullivan concluded that “parties are free to impose conditions precedent to the attachment of excess policies in order to prevent such a result…[t]he Excess Insurers, demonstrating impressive foresight, obviously chose to do so here.”

¹  The insurance tower is as follows:

²  Federal’s policies specifically contained language stating:
[T]he Underlying Policy(ies)…shall be maintained during the Policy Period in full effect and affording coverage at least as broad as the Primary Policy, except for any reduction of the aggregate limit(s) of liability available under the Underlying Insurance solely by reason of payment of losses thereunder[.]

³  Koppers Co. v. Aetna Cas. & Sur. Co., 98 F. 3d 1440 (3d Cir. 1996) and Zeig v. Mass Bonding & Ins. Co., 23 F.2d 665 (2d Cir. 1928). Both cases concern circumstances where the underlying policy was exhausted by virtue of an insured’s settlement with an underlying carrier.

Tressler Comments:  This decision compliments articles discussing Zeig as featured in our August and September 2011 editions of this newsletter, and previously follows a series of recent cases in which courts have undermined a party’s reliance on Zeig. That is not to say, however, that this decision overrules or invalidates Zeig. Zeig was an exhaustion of limits case, and not one dealing with a “drop down” per se. Nonetheless, the Southern District Court’s decision is a major triumph for excess insurers in upholding fundamental policy provisions regarding the maintenance of underlying policies. Looking down the road, the insureds, who are comprised of former directors and officers of Commodore or their estates, are in a difficult bind. They no doubt attach all of the layers in the tower at some point, but that would involve them paying a total of $15¹ million to the underlying plaintiffs in order to exhaust the Reliance and Home layers. This is likely not a palatable notion to these insureds, and perhaps not one that they have the financial wherewithal to satisfy.

¹ Conceivably, the insureds might be able to pay less if there is some recovery from the estates of Reliance and The Home.

Fidelity Corner: Eleventh Circuit Holds “Employee Theft” Coverage Does Not Apply to Employee’s Secret Profit From Selling Property to Employer
Authored by:
Jim Knox, Partner in the Chicago Office
Michael DiSantis, Associate in the Chicago Office

In recent years, many insureds became disenchanted with the requirement of “employee dishonesty” coverage that the employee act with “manifest intent.” Some of them demanded “employee theft” coverage, with no express language about intent. Insurers obliged, with some trepidation. In Hartford Fire Ins. Co. v. Mitchell Co., Inc., 2011 U.S. App. LEXIS 18643 (11th Cir. Sept. 8, 2011), however, this change yielded, if anything, less coverage, not more. The Eleventh Circuit held that employee theft coverage did not extend to a scheme in which an employee bought properties and then sold them to the insured for an inflated amount.

Hartford’s policy covered loss resulting directly from theft by an employee and defined theft as “the unlawful taking of ‘money’ . . . to the deprivation of the Insured.” The insured, Mitchell Co., was a developer. The officer in charge of single family developments dishonestly “flipped” properties he and an accomplice bought from third parties by selling them to the insured at a profit without disclosing his interest or the kickbacks he was getting from the accomplice. Mitchell claimed a loss in the amount of the difference between what the employee paid for the properties and what the insured paid for them.

Mitchell argued this was theft because the employee violated civil and criminal law. At a minimum, it was “theft by deception” under state law because the employee secretly profited at his employer’s expense. The district court agreed the conduct may have been unlawful but concluded it was not theft of money. It was not even “theft by deception.” There was no evidence the employee presented false information to Mitchell about the properties.

The Eleventh Circuit agreed there was no coverage. The employee did not commit theft because he did not unlawfully take funds from Mitchell and deprive it of money without its knowledge. It was not simply that Mitchell was claiming an excluded lost profit; Mitchell did not prove it suffered a loss at all. Mitchell “decided to purchase properties, approved the purchase price, paid the purchase price, and received the exact property for which it bargained. Ultimately, [Mitchell] did not inadvertently or involuntarily depart with money, but instead willingly paid a known purchase price for a known quantity.”

The court distinguished FDIC v. National Union Fire Ins. Co., 205 F.3d 66 (2d Cir. 2000), in which the bond covered loss resulting directly from a dishonest or fraudulent act by an employee. Hartford’s policy, however, covered “loss by theft, not dishonesty.” This may not stop the migration but insureds and their brokers will want to take greater care not to read too much in the words “employee theft.” Fidelity insurers never intended to cover anything beyond direct embezzlement-type losses to the insured. They did not change their mind by writing employee theft instead of employee dishonesty coverage. 

Dishonesty Exclusion Bars Coverage for Bankrupt Entity Based on Fraudulent Conduct of Controlling Directors and Officers
Authored by:
Kathryn Formeller, Associate in the Chicago Office

A dishonesty exclusion barred coverage under an excess Directors’ and Officers’ policy for the Wrongful Acts of the Principals of a bankrupt company, all of whom were criminally convicted of fraud and related crimes. In The Unencumbered Assets Trust v. Great American Insurance Co., et. al., 2011 WL 4348128 (S.D. Ohio Sept. 16, 2011), the U.S. District Court for the Southern District of Ohio further held that a question of fact existed as to whether the excess policy was void ab initio for material misrepresentations made on the application for insurance because the excess insurer accepted premium payments for tail coverage. 

Gulf Insurance Company (“Gulf”) and Great American Insurance Company (“Great American”) issued two separate Directors’ and Officers’ policies to National Century Financial Enterprises, Inc. (“National Century”). The primary policy was issued by Gulf and provided $5 million of coverage. Great American issued an excess policy for an additional $5 million of coverage, effective upon exhaustion of the Gulf policy. The insureds under both policies were National Century and its directors and officers.

When the policy period ran, National Century purchased tail coverage under both policies, giving it an additional one-year discovery period for bringing claims that arose during the original policy period. Great American’s excess policy was a “follow form” to Gulf’s policy with a few additions and limitations. The Gulf policy contained a dishonesty exclusion that barred coverage for claims where the insured committed a fraudulent or dishonest act. Gulf’s policy also provided that an untrue statement or misrepresentation in the insurance application would render the policy void ab initio with respect to those who knew the statements were untrue.

National Century was in the business of purchasing accounts receivable at a discount from healthcare providers. National Century’s Principals used their power over National Century and its subsidiaries to defraud investors by issuing notes to investors that the Principals represented were secured by healthcare receivables. Many of the accounts receivable that National Century purchased were worthless or nonexistent, and much of the capital raised went to companies in which the Principals had undisclosed ownership interests. National Century’s Principals also issued fabricated financial reports.

National Century’s fraudulent scheme led to its bankruptcy. Soon after, National Century’s investors filed numerous civil actions against the Principals, outside directors, and other persons and entities involved in National Century’s fraudulent scheme. The Unencumbered Asset Trust (“UAT”) was created by the bankruptcy court to pursue claims belonging to National Century and its subsidiaries. The UAT filed an adversary proceeding against Gulf and Great American seeking a declaration that the policies were enforceable and requesting an apportionment of the policies’ proceeds among the insureds. Gulf filed a motion to deposit the policy limit and obtain a discharge of liability. The bankruptcy court granted the motion and Gulf deposited $5 million into an escrow account.

In the meantime, the government successfully pursued criminal charges against each of the Principals involved in National Century’s fraudulent scheme. Based on their roles in the fraud, each of the Principals was convicted in criminal proceedings. The Principals were convicted of securities fraud, wire fraud, conspiracy to commit those crimes, money-laundering conspiracy, and concealment of money laundering. The Principals’ convictions were later affirmed by the Sixth Circuit Court of Appeals. Subsequently, the Principals filed motions for partial summary judgment to require Great American to pay their defense costs. The Principals argued that they qualified as insureds under Great American’s policy; they incurred substantial defense costs; and the Gulf policy had been exhausted thereby triggering Great American’s duty to pay.

Great American disputed coverage arguing that the convictions of the Principals triggered the dishonesty exclusion and that the fraud committed in the procurement of the policy rendered the policy void ab initio. The Principals argued that the dishonesty exclusion did not apply because not all of their convictions were “final.” The District Court found that the plain language of the dishonesty exclusion was satisfied. The Principals were convicted of crimes having fraudulent conduct as an element of the offense. Further, the defense costs for which the Principals sought coverage were directly related to the claims against them that were brought by their fraudulent and dishonest conduct. The District Court rejected the Principals’ finality argument reasoning that the type of finality asserted by the Principals is not required to trigger the dishonesty exclusion. The policy requires only “a judgment or other final adjudication adverse to such insured” establishing deliberately fraudulent or dishonest acts. The policy did not require full exhaustion of appellate review as claimed by the Principals.

UAT contended that, to the extent the dishonesty exclusion was triggered, the adverse interest exception protected UAT’s right to coverage, as the Principals’ fraud should not be imputed to National Century (or its successor-in-interest, UAT) because the Principals were acting on their own behalf. Great American argued that the adverse interest exception was overcome by the sole actor rule because the Principals’ wrongdoing was directly attributable to National Century as the Principals dominated and controlled National Century. Further, UAT’s claim for coverage relates to the wrongdoing of the Principals and National Century, which was fully dominated by the Principals. In opposing the sole actor rule, UAT argued that the innocent “insider exception” applied. UAT claimed that National Century’s outside directors could have stopped the fraud had they known about it. The District Court rejected this argument for the same reasons it rejected the sole actor rule further noting that no Ohio court has adopted such an exception.

Great American next argued that it was entitled to rescind the excess policy as void ab initio because the false representations made in the policy proposal form rendered the policy null and void. UAT contended that no provision in Great American’s policy permitted it to rescind the policy as void ab initio and that Great American waived its right to rescind when it accepted the premium payment for tail coverage. UAT argued that Great American’s excess policy had its own endorsement concerning the effect of misrepresentation that conflicted with Gulf’s “void ab initio” language. The District Court rejected this argument finding that the two clauses provided alternative, not conflicting, remedies to Great American.

In determining whether Great American’s policy language allows the policy to be voided ab initio, the court applied the Boggs test.

Statements by an insured fall into two classes-those which constitute warranties, and those which constitute representations. If the statement is a warranty, a misstatement of fact voids the policy ab initio. However, if the statement is a representation, a misstatement by the insured will render the policy voidable, if it is fraudulently made and the fact is material to the risk, but it does not void the policy ab initio. A representation is a statement made prior to the issuance of the policy which tends to cause the insurer to assume the risk. A warranty is a statement, description or undertaking by the insured of a material fact either appearing on the face of the policy or in another instrument specifically incorporated in the policy.

The District Court noted that material misrepresentations were undoubtedly made in the proposal form. Additionally, the District Court found that the policy could be declared void ab initio for the following reasons: (a) the misstatements of material facts in the proposal form were warranties, rather than representations; (b) the proposal form was incorporated into the policy; (c) the terms of the policy clearly and unambiguously provided that a misstatement by the insured would render the policy void ab initio; and (d) a clause in the proposal form modified Gulf’s severability language and expressly provided that the Principal’s knowledge of material facts when he signed the proposal form would be imputed to other insureds for purposes of determining the validity of the policy.

Despite such findings, the District Court refused to declare the policy void ab initio because a genuine issue of material fact existed as to whether Great American knew about the financial misstatements in the proposal form at the time it accepted the premium payment for tail coverage, and therefore waived its right to rescind the policy. The District Court pointed out that National Century filed for bankruptcy four months prior to applying for tail coverage. Thus, a question of fact remained as to whether Great American knew about National Century’s bankruptcy and falsified financial records when tail coverage was purchased.

Tressler Comments:  This decision addressed two important issues, whether an insurer is entitled to rescission when it later accepts premium payments for tail coverage, and whether the fraudulent and dishonest acts of individual directors and officers may be imputed to the entity so that coverage is precluded for the entity under the dishonesty exclusion. Although the court found that material misrepresentations were made in the insurance application that rendered the policy void ab initio, the court refused to grant rescission because a question of fact remained as to whether the insurer had waived its right to rescind the excess policy because it knew about such misrepresentations when it accepted the premium payments for tail coverage. This outcome emphasizes the importance of timeliness when it comes to a claim for rescission. With regard to the dishonesty exclusion, the court applied agency law principles to conclude that the directors’ and officers’ fraudulent conduct should be imputed to the bankrupt company and the successor-in-interest trust, which stood in the bankrupt company’s shoes.

This decision is also significant for excess insurers with “follow form” provisions. The court relied on the provisions in the primary policy to determine whether the excess insurer was entitled to rescission, even though its policy contained alternative language regarding misrepresentations.

The Southern District of New York Limits Coverage for Insureds Pursuant to “Criminal Act” Exclusion and “Imputation” and “Consent-to-Settle” Provisions
Authored by:
Kyle P. Barrett, Associate in the New York Office

In Federal Insurance Company v. SafeNet Inc., et al., Case No. 09-CV-7863 (S.D.N.Y. September 9, 2011), the United States District Court for the Southern District of New York held that criminal act exclusions barred coverage for an “Insured Person,” and that such fraudulent conduct and knowledge could be imputed to the insured entity. The court further held that a consent to settle provision barred coverage for settlement where insurer had not issued a blanket denial of coverage. 

On May 18, 2006, SafeNet announced that it had received a subpoena “from the office of the United States Attorney for the Southern District of New York relating to [its] granting of stock options,” and that it had “received an informal inquiry from the Securities and Exchange Commission requesting information relating to stock option grants to directors and officers…[and] to certain accounting policies and practices.” These developments spurred a string of investigations and legal proceedings against SafeNet, including a shareholder class action, a Securities and Exchange Commission enforcement action and a criminal indictment in the Southern District of New York against Carole Argo, SafeNet’s Vice President and Chief Financial Officer. Argo eventually pleaded guilty, in October 2007, to securities fraud related to the backdating of SafeNet stock options. Additionally, in November 2009, the SEC filed a civil injunctive action against SafeNet, Anthony Caputo, SafeNet’s Chairman and Chief Executive Officer, another former Chief Financial Officer and three SafeNet accountants. This action was settled the day the complaint was filed with the defendants not admitting or denying the complaint’s allegations.

On February 28, 2006, SafeNet provided National Union and Federal¹ with notice of the 8-K Disclosure, which both insurers accepted as a notice of circumstances. Also, in June 2006, SafeNet provided National Union with notice of several investigations and lawsuits, which National Union, in turn, provided to Federal.

On October 16, 2006, National Union advised SafeNet that any coverage available for the Class Action would only be available under the 05-06 Primary Policy. However, on April 21, 2008, National Union advised that SafeNet was no longer entitled to coverage under the 05-06 Primary Policy due to Argo’s guilty plea. On June 27, 2008, Federal advised SafeNet that the 05-06 Excess Policy applied to the Claim and that it was investigating the issue of rescission with respect to the 05-06 Excess Policy.

Additionally, in late 2010, SafeNet settled the Class Action for $25 million and subsequently paid this amount. SafeNet did not notify Federal of settlement negotiations nor did it seek Federal’s consent prior to settling.

In September 2009, Federal filed a declaratory relief action against SafeNet, Argo and Caputo seeking declaration of its coverage obligations under the 05-06 and 06-07 Excess Polices and rescission of the 05-06 Excess Policy. Following a denial of defendants’ motion to dismiss, the parties filed cross motions for summary judgment. In its motion, Federal sought the following rulings: (1) a declaration that the 05-06 Excess Policy does not provide coverage for Argo or SafeNet; (2) a declaration that the 05-06 Excess Policy does not provide coverage for any “Insured Person” because no “Insured Person” incurred a Loss in connection with the recently settled Class Action; (3) a declaration that even if an Insured Person incurred a Loss, no coverage is available unless the Insured Person could establish: (a) that the loss was Non-Indemnifiable; and (b) he or she lacked actual knowledge of facts not accurately disclosed in SafeNet’s Application; and (4) a declaration that there is no coverage for the settlement of the Class Action in light of SafeNet’s failure to notify plaintiff or seek its consent.

The defendants sought the following rulings: (1) a declaration that claims concerning stock option backdating fall within the 2006- 2007 policy period, not the 2005- 2006 policy period; (2) a declaration that Federal has waived its right to seek rescission of the 06-07 Excess Policy; and (3) a declaration that SafeNet and other Insureds did not need to seek Federal’s consent before settling the Class Action in light of Federal’s prior denial of coverage.

In adjudicating this matter, the United States District Court for the Southern District of New York (the “Court”) determined that Maryland law would apply as Maryland is SafeNet’s principal place of business and the principal place of insured risk.

The Court first addressed which Excess Policy applied to SafeNet’s claims. Federal argued that the 05-06 Excess Policy applied based on both the 05-06 and 06-07 Excess Policies’ broadly worded “relation-back provisions.” The Court agreed, noting that plaintiffs in the Class Action alleged that the financial irregularities disclosed in the February 2006 Notification and the alleged stock options backdating were part of an interrelated course of conduct. Thus, the Court held that the Class Action related to the original February 2006 Notification, and therefore the 05-06 Excess Policy applied.

Next, the Court held that neither the 05-06 Excess Policy or 06-07 Excess Policy provided coverage to Argo as both policies have “criminal act” exclusions, which provide that Federal is not liable to make payments “arising out of, based upon or attributable to the committing of any deliberate criminal or fraudulent act by the Insured if a judgment or final adjudication . . . adverse to the Insured(s) establishes that such deliberate criminal or fraudulent act was committed.” Thus, because Argo pleaded guilty to fraudulent acts and allocuted to willful and deliberate conduct resulting in a sentence being entered against her, the Court determined that the 05-06 and 06-07 Excess Policies’ “criminal act” exclusions applied to bar coverage for Argo.

The Court then determined whether any coverage was available for SafeNet. Federal argued that the 05-06 Excess Policy’s “personal profit” and “criminal act” exclusions coupled with an “imputation provision,” applied to bar coverage for SafeNet. The “imputation provision” states that “[f]or purposes of determining whether knowledge shall be imputed to an Insured: (1) knowledge possessed by a past or present, {i} chief executive officer or {ii} chief financial officer of the Named Entity shall be imputed to all Insureds . . .” The defendants argued that the “imputation provision” did not survive the incorporation of Endorsement No. 3 into the 05-06 Excess Policy, which inserts the need for a “final, adverse judgment” into the language of the “personal profit” and “criminal act” exclusions. Further, the defendants argued that even if the “imputation provision” were to apply, it only permits the imputation of “facts” and “knowledge” to SafeNet, not a judgment. The Court agreed with Federal that the “imputation provision” is applicable, but agreed with the defendants that only “facts” and “knowledge” would be imputed to SafeNet, not a judgment. Thus, the Court held that the 05-06 Excess Policy’s “personal profit” and “criminal act” exclusions did not bar coverage for SafeNet. The Court held that the same conclusion would be reached under the terms of the 06-07 Excess Policy.

Next, the Court held that it could not make a decision on the issue of whether other Insured Persons were covered as there was no record evidence that SafeNet indemnified any particular officer or director. On the issue of the “consent-to-settle” provision in connection with settlement of the Class Action, the Court held that because Federal had not issued a blanket denial of coverage, but instead advised that it was investigating its obligations under the 05-06 and 06-07 Excess Policies and possible partial rescission, the “consent-to-settle” provision applied and SafeNet could not recover the Class Action settlement amount.

Lastly, on the issue of partial rescission of the 05-06 Excess Policy, the court interpreted Endorsement No. 4 to the 05-06 Excess Policy, which states that “it is agreed that the Insurer has relied upon the statements, warranties and representations contained in the Application as being accurate and complete. All such statements, warranties, and representations are the basis for the policy and are material to the risks assumed by the Insurer.” Further, Endorsement No. 4 provides that “this Policy shall be void as to any Insured who knew as of the inception date of the Policy Period of the facts that were not accurately and completely disclosed in the Application (whether or not the Insured actually knew the facts were not accurately disclosed in the Application) and as to any Insured to whom such knowledge is imputed.” The Court held that it was clear that Argo, who signed SafeNet’s public filings and pleaded guilty to securities fraud, knew of inaccuracies in the Application for the 05-06 Excess Policy. Thus, the Court held that the 05-06 Excess Policy was void ab initio as to Argo. Further, the Court held that because Argo was SafeNet’s Chief Financial Officer and because her knowledge is imputed to SafeNet, Argo’s guilty plea renders the 05-06 Excess Policy ab initio as to SafeNet.

Accordingly, Federal’s motion for summary judgment was granted in part and denied in part, and defendants’ cross motion for summary judgment was denied.

¹ SafeNet purchased directors and officers liability insurance policies for the March 12, 2005 through March 12, 2006 policy period. National Union Fire Insurance Company of Pittsburgh provided the first layer of coverage which had a $10 million limit of liability (the “05-06 Primary Policy”). Federal Insurance Company provided the second layer of coverage, providing $5 million in excess coverage (the “05-06 Excess Policy”). SafeNet also purchased directors and officers liability insurance policies for the March 12, 2005 through March 12, 2007 policy period. National Union provided the first layer of coverage which had a $10 million limit of liability (the “06-07 Primary Policy”) and Federal provided the second layer of coverage, providing $5 million in excess coverage (the “06-07 Excess Policy”).

Tressler Comments:  The SafeNet ruling is strong caution to insureds who may seek to settle a claim without insurer consent. It also demonstrates the importance of “imputation” language in D&O policies in connection with insurers’ and insureds’ efforts to determine whether, and the extent to which, coverage may be excluded or a policy rescinded. Here, the court found that as to the exclusions, Insured Person conduct would not be imputed to the entity. Statements in the Application, however, were imputed to the entity – and the policy determined to be void ab initio as to all insureds, a much harsher result.

Prior Knowledge Precludes Coverage for All Interrelated Claims Against “Innocent Insured”
Authored by:
Jillianne M. Argello, Associate in the New York Office

On September 2, 2011, the United States District Court for the District of South Carolina, in an action styled Continental Casualty v. James R. Jones, et al., Case no. 09-cv-01004 (the “Jones action”) resolved a coverage dispute involving two professional liability policies issued by the plaintiff, Continental Casualty Company (“Continental”). The court’s ruling, which granted summary judgment in favor of Continental, relies in part on the Fourth Circuit Court of Appeals’ March 24, 2011 decision in the Bryan Brothers Inc. v. Continental Casualty Co. Case no. 10-1439) (the “Bryan Brothers decision”).

THE BACKGROUND

The insured, James Jones, operated a solo law practice, and additionally served as a partner in an accounting practice with another accountant. In the course of his business, Jones created one operating account to be used by his law practice and his accounting practice. Continental issued an insurance policy to the law practice for the period of September 2, 2007, through September 2, 2008, and two successive accountants professional liability policies to the accounting practice for the period of January 12, 2007, through January 12, 2008, and January 2008 through 2009. Prior to the inception of both the lawyers professional liability policy and the accountants policies, Jones began misappropriating significant amounts of client funds, and the misappropriations were discovered over a year and a half later, after the inception of both policies. Multiple lawsuits stemming from these thefts were subsequently filed against the law practice, the accounting practice, Jones, and his accounting partner. The insureds sought coverage under both the lawyer policy and the accountant policies. 

THE POLICIES APPLICATION

With respect to the professional liability policy Continental issued to Jones’ law practice, Jones submitted a renewal application for coverage on July 26, 2007 (“Lawyers Application”), including question 3 that inquired whether:

During the current/existing policy period, are there any claims, acts or omissions that may reasonably be expected to be the basis of a claim against the firm that (a) have not been reported to the Company OR (b) were reported to the Company?

Question 4 of the Lawyers Application further inquired whether:

the firm, or any attorney affiliated with the firm, [is] aware of any acts, omissions or circumstance which a reasonable person would expect may give rise to a professional liability claim in the future against the firm, any predecessor firm, or any current or former attorney of the firm while affiliated with the firm?

Finally, the Lawyers Application provides that with respect to Question 4:

Any such act, omission, or circumstance must be disclosed regardless of whether it is considered likely that claim will in fact be made.

Jones answered “no” to both questions, and subsequently submitted a warranty letter affirming that his responses on the Lawyers Application had not changed and that he had not become aware of any acts or omissions which a reasonable person would view as likely to give rise to a claim.

Jones’ partner in the accounting business, who was not alleged to have any knowledge of Jones’ misappropriation of client funds, completed the applications for the Accountants Policy.

THE DISTRICT COURT’S DISPOSITION

The Court dispensed quickly with Continental’s unopposed motion for summary judgment with respect to rescission of the Lawyers Policy, as there was no dispute with respect to any element of its claim. The court noted that Jones admitted that he stole money from clients of his law firm, and that he knew his misconduct would give rise to a claim against him and his law firm, and further admitted that he lied on his application for professional liability insurance with the intent to defraud the insurer because he knew that if he disclosed his criminal conduct, Continental would not provide him with coverage.

The real issue to be decided by the Court involved the interplay between the Accountants Policy’s prior knowledge provision and the innocent insured provision in connection with coverage for claims made by Jones’ clients against the accounting firm and Jones’ partner.

The insuring clause of the Continental Accountants Policy (the “Accountants Policy” or the “Accountant Policies”) conditioned coverage on, inter alia, the following:

prior to the effective date of this Policy, none of you had a basis to believe that any such act or omission, or interrelated act or omission, might reasonably be expected to be the basis of a claim.

Continental argued that it did not have a duty to defend or indemnify Jones, his partner, or the accounting firm for any claims made against them arising out of Jones’ misconduct because a condition precedent to coverage under the policy was that prior to policy inception, no insured had knowledge of an act reasonably likely to become the basis for a claim against the accounting firm. Continental argued that because Jones, an insured under the Accountants Policies, had knowledge of his own intentional misconduct prior to the inception of the 2007-2008 and 2008-2009 Accountants Policies, the prior knowledge condition within the Accountants Policies had not been satisfied.

Continental relied on the Fourth Circuit’s recent Bryan Bros. decision, which involved an identical issue and identical professional liability policy issued by Continental to an accounting firm. The Bryan court, applying Virginia law, held that the prior knowledge provision was a condition precedent to coverage under the policy, and that an insurer’s coverage obligation is not triggered if an insured fails to fulfill a condition of an insurance policy. The Jones court, finding that same result would be achieved under South Carolina law, applied the Bryan Bros. court’s ruling and concluded that Continental’s coverage obligation under the Accountants Policy had not been triggered. The court rejected Jones’ accounting partner’s argument that the “innocent insureds” provision of the policy would operate to provide coverage for the members of the accounting practice that did not participate in the misconduct. The court reasoned that the “innocent insureds” provision does not require Continental to provide coverage under the Accountants Policy because the claims made against Jones, his partners, and the accounting practice are all “interrelated” as that term is defined in the Accountants Policy -- all arose out of Jones’ scheme to defraud his clients of money -- and Jones’ failure to disclose this to Continental on the application for the Accountants Policy barred coverage.

Finally, in their motion for summary judgment, defendants argued that Continental is estopped from denying coverage under the 2008-2009 renewal policy or tail policy, because it renewed the Accountants Policy and allowed the accounting firm to purchase tail coverage after it had knowledge of Jones’ theft of client funds. The court rejected this argument, concluding that the renewal accountants’ policy and the tail coverage it purchased when the initial policy expired remains in full effect and provides meaningful coverage for the insureds.

The court ultimately granted Continental Casualty’s motion for summary judgment, entitling Continental to rescind the Lawyer’s Policy, and concluded that it has no obligation to provide defense or indemnity coverage to Jones for any past, present or future claims arising from his law practice. Additionally, the court ruling provided that Continental had no duty to defend or indemnify any insured under the Accountants Policy for any claims stemming from interrelated with Jones’ scheme.

Tressler Comments:  The court’s ruling in the Jones action, and the Fourth Circuit’s decision in Bryan Bros., reflect a noteworthy application of an “innocent insured” provision where the lack of prior knowledge is incorporated into a policy’s insuring clause as a condition precedent to coverage, rather than as a policy exclusion.

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