The typical D&O insurance policy precludes coverage
for loss arising from fraudulent misconduct. But when an insured has been
convicted of fraud, whose coverage is precluded? In the second case in recent
days to address the consequences for the insured entity of the criminal
conviction of one of the entity's principals, Judge James L. Graham of the
Southern District of Ohio held on September 16, 2011 that the criminal
convictions of several principals of National Century Financial Enterprises
preluded D&O insurance coverage not only for those individuals but for the
insured entity's successor in interest as well. Judge Graham's opinion, which
addresses a number of recovering issues, can be found here.
National Century had been in the business of purchasing
accounts receivable at a discount from healthcare providers and then raising
capital by issuing investment grade notes backed by the receivables. It later
emerged that many of the accounts receivable were worthless or nonexistent, and
the funds raised through the notes offerings were paid to healthcare companies
in which principals of National Century held undisclosed ownership interest.
The principals of the company caused National Century to issue financial
reports that were entirely fabricated.
Eventually the multibillion dollar scheme collapsed and
National Century filed for bankruptcy. Several of the principals of National
Century were ultimately convicted of a variety of criminal charges. The
principals appealed their criminal convictions and while their convictions on
certain of the charges were overturned, their convictions were otherwise
During the period March 28, 2002 to March 28, 2003,
National Century had a $10 million D&O insurance program in place, arranged
with a $5 million primary policy and an additional $5 million follow form policy
excess of the primary $5 million. Though these policies were to expire on March
28, 2003, National Century exercised an option under both policies to purchase
an additional one year of discovery coverage for claims that arose during the
original policy period.
The Unencumbered Asset Trust (UAT), which was created by
the bankruptcy court to pursue claims belonging to National Century and its
subsidiaries, filed an adversary action against the company's D&O insurance
carriers seeking a judicial declaration that the policies were enforceable and
requesting an equitable apportionment of the policies' proceeds among the
insureds. The primary carrier filed a motion to deposit its policy limits in
the registry of the court and to obtain a discharge of its liability. The
bankruptcy court granted this motion and later apportioned the $5 million
primary policy among UAT (which received $1.5 million) and seven individuals
(who received $500,000 each).
Contrary to the actions of the primary carrier, the
excess carrier disputed coverage and filed a counterclaim seeking rescission of
its policy and seeking a declaratory judgment that the excess policy was void.
After additional proceedings, the parties to the insurance coverage action
filed cross motions for summary judgment. UAT argued that the excess carrier
was not entitled to rescission and in any event had waived its right to
rescind. UAT also argued that the principals' criminal conviction cannot be
imputed to the entity, and therefore the fraud exclusion did not preclude
coverage for the entity (and its successor in interest, UAT).
In his September 16, 2011 opinion, Judge Graham held,
based on the misrepresentations in the company's financial statements, which
statements were incorporated by reference into the application and therefore
into the policy, that the excess insurer had a substantial basis on which to
rescind the policy. However, he found there was a genuine issue of material
fact on the questions of whether the excess carrier had waived its right to
rescission by agreeing to issue the discovery coverage and by accepting the
premium for the discovery coverage. (By the time the discovery coverage was
acquired, National Century had already filed for bankruptcy and allegations of
misconduct had already come to light.)
Judge Graham had little difficulty concluding that, as a
result of their criminal convictions, coverage under the excess policy for the
convicted individuals' loss was precluded by the policy's fraud exclusion.
Lance Poulson, the company's founder and former President and Chairman, had
tried to argue that the exclusion could not be applied to him because he still
has the option of filing a petition for a writ of certiorari to the U.S.
Supreme Court, and therefore the "adjudication" of his criminal misconduct was
not yet "final."
Judge Graham rejected this argument holding that the
"type of finality" that Poulson "espoused" is "not required to trigger the
fraud exclusion." Rather the exclusion requires only "a judgment or other
final adjudication adverse to such Insured." Judge Graham found that this
provision "speaks nothing of exhaustion of appellate review." Poulson's
criminal conviction alone was held sufficient to establish the applicability of
Judge Graham then turned to the question of whether or
not these individuals' fraudulent misconduct could be imputed to UAT, the
entity's successor in interest. Many policies have specific provisions designed
to address to whom and how insured persons' conduct will be imputed, but Judge
Graham's opinion does not reference any policy language in connection with the
question whether or not the individuals' fraudulent misconduct could be imputed
to the entity. Instead, his analysis turned on various aspects of agency law
addressing the question of whether and when the conduct an agent acting on his
or her own account can be imputed to their principal. Judge Graham held that
because the individuals so dominated the principal the principal itself had no
separate existence or identity, and therefore their financial fraud must be
imputed to the entity.
Judge Graham's conclusion here that the individuals'
fraudulent misconduct could be imputed to the entity (and its successor in
interest) stands in interesting contrast to Southern District of New York Judge
Naomi Reice Buchwald's September 9, 2011 decision in the SafeNet coverage case
(about which refer here),
in which Judge Buchwald held that the criminal guilty plea of SafeNet's CFO
could not be imputed to SafeNet itself for purposes of determining the applicability
to SafeNet of its excess D&O insurance policy's fraud exclusion.
The difference in outcome between the two cases may be
due in part to the fact that in the SafeNet case, Judge Buchwald was
interpreting the imputation language in the policies at issue, whereas here
Judge Graham was applying general agency law principles. In the SafeNet case,
even though the relevant policy language provided that knowledge and facts
could be imputed to company, the adjudication of the CFO's criminal misconduct could
not be imputed to SafeNet. That is, the imputation to the company under the
policy's language was limited to "facts" and "knowledge," whereas here, Judge
Graham found that the individuals' fraudulent misconduct could be imputed to
the company and its successor in interest.
I do wonder whether or not this apparent distinction
really does explain the difference in outcome, though. The relevant
exclusionary language at issue here precludes coverage for loss in connection
with any claim against any insured "brought about or contributed to by any
deliberately fraudulent or deliberately dishonest act or omission. by such
Insured" but only "if a judgment or final adjudication adverse to such
Insured establishes such a deliberately fraudulent or deliberately
fraudulent dishonest act or omission." (Emphasis added)
I don't know whether the entity's successor in interest
raised this argument but it seems like it could have been argued that there had
been no adjudication adverse to the entity as required in order for the
exclusion to preclude coverage for the entity. Even if as Judge Graham
found that the individuals' misconduct can be imputed to the entity and its
successor as a result of the application of agency law principles, there does
not seem to be anything that would impute the adjudication of those
individuals' misconduct to the entity. That was certainly the reasoning of
Judge Buchwald in the SafeNet case.
It may be purely coincidental, but I do think it is
noteworthy that in both the SafeNet case and this case the coverage issues were
being raised not by the primary insurers but rather by the excess insurers.
This is yet another example of a phenomenon I have noted before on this site,
which is that so many of the litigated coverage disputes seem to involve excess
The procedural step taken by the primary carrier here may
be particularly of interest in light of the issues recently raised in the
Lehman Brothers case (about which refer here).
The individual officers and directors of the Lehman subsidiary are trying to
contend in the Lehman bankruptcy that they are entitled to some type of
equitable apportionment of the remaining D&O insurance. The difference
between that proceeding and what occurred here with respect to the primary
carrier's policy proceeds is that here the primary insurer here
deposited its policy proceeds with the court (presumably through some
type of interpleader). The Lehman bankruptcy court may lack an equivalent
procedural context for the type of apportionment that the Lehman subsidiary
executives seek. But it is nevertheless interesting to seen an example of a
situation where a court provided for the equitable apportionment of insurance
proceeds along the lines that the Lehman subsidiary executives are seeking in
the Lehman bankruptcy.
In any event, it is probably worth noting that even
though Judge Graham concluded that the fraud exclusion precludes coverage for
the convicted individuals and for the entity's successor in interest, that is
not the end of this matter. There are other insured persons seeking the benefit
of the policy proceeds. These persons include the company's former outside
directors and Poulson's wife., who was also an officer of the company. These
persons were not criminally convicted. So as a result of Judge Graham's
conclusion that the are genuine issues of material fact on the question of
whether or not the excess insurer waived its right to policy rescission, this
case must go forward in order to determine whether or not those individuals do
or do not have coverage under the excess policy.
Hartford Financial Subprime-Related Securities
Suit Dismissed: Speaking of Judge Buchwald, on September 19,
2011, she granted with prejudice the motion to dismiss of the defendants in The
Hartford Financial Services subprime-related securities class action lawsuit.
A copy of Judge Buchwald's opinion can be found here.
As discussed here, the plaintiffs filed suit against the
company and certain of its directors and officers in March 2010, alleging that
the company had failed to disclose its growing exposure to derivatives and
hedging contracts, the deterioration of which had caused the company's public
statements about its financial condition to become inaccurate. The plaintiffs
also alleged that the company used inflated valuations for mortgage-backed
assets on the company's balance sheet, which resulted in an overstatement of
the company's capital position.
In granting the defendants' motion dismiss, Judge
Buchwald noted that the plaintiffs' allegations were "unusual" because they did
not allege that the company had violated GAAP or even that the company's
regulatory filings contained a misrepresentation or omission. Instead, she
noted, "plaintiffs base their entire complaint on a unilateral, and ultimately unsupported,
interpretation of The Hartford's insurance filing, and their belief about what
this document reveals about defendants' state of mind and valuation of
assets." The plaintiffs, she said, have made "an unfounded assumption
about the year-end insurance filings and follow that with a series of equally
unfounded extrapolations based on this flawed assumption."
I have in any event added Judge Buchwald's ruling in The
Hartford case to my running tally of subprime-related lawsuit dismissal motion
rulings, which can be accessed here.
Nate Raymond's September 19, 2011 Am Law Litigation Daily article about
the dismissal in The Hartford case can be found here.
FDIC Failed Bank Lawsuits Will Peak in 2012?: In yesterday's
post, I noted that the FDIC's lawsuit filing activity picked up momentum in
August. I also suggested that in light of the timing of bank closures and the
seeming lag time between prior closures and later lawsuits, it appears that
there will be many more lawsuits in the months ahead, particularly as we head
In a September
19, 2011 post on the blog of the Joseph
& Cohen law firm, Jon Joseph
presents his analysis which he believes shows that the FDIC's failed bank
litigation filings are likely to peak in 2012. Joseph has a number of
interesting observations about the cases the FDIC has filed so far as part of
the current wave of bank failures and has some interesting speculations about
what may lie ahead, in particular about how many lawsuits are yet to come and
when they are likely to be filed. Among other things he speculates based on the
current number of bank failures that there will be lawsuits in connection with
about 80 additional failed banks, beyond the 14 lawsuits that have been filed
other items of interest from the world of directors & officers liability,
with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.
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