On the Importance of Reading the Fine Print in Excess D&O Policies

On the Importance of Reading the Fine Print in Excess D&O Policies

 Peter M. Gillon, Partner, Pillsbury Winthrop Shaw Pittman LLP

A recent ruling by the United States Court of Appeals for the Second Circuit, affirming the decision of District Court Judge Gerard Lynch in XL Specialty Ins. Co. v. Agoglia, 2009 U.S. Dist. LEXIS 36601 (S.D.N.Y. Apr. 30, 2009), provides an object lesson in the importance of reviewing excess D&O policies for conformance to the primary policy.  Murphy v. Allied World Assurance Company (US), Inc., 2010 U.S. App. LEXIS 5915, (2d Cir. Mar. 23, 2010)(Summary Order).

Agoglia is a D&O coverage dispute arising from the collapse of Refco, brought on by the revelation at the time of Refco's IPO that the company had a $435 million receivable from an entity controlled by its CEO, Philip Bennett.  There was little question that Bennett's knowledge of this receivable, established in Bennett's stipulated judgment, precluded coverage for him under the company's D&O policies by operation of the "prior knowledge" exclusion, which bars coverage where any insured had knowledge of facts which are likely to give rise to a claim at the inception of the policy.  (Slip op. at 16).  The key issue was whether coverage was preserved for the innocent directors and officers.

The Refco primary policy included a severability of knowledge provision, also known as a "non-imputation" clause, the effect of which in this circumstance is that prior knowledge of claims by one director would not cause forfeiture of coverage for innocent directors.  The dispute centered on whether the severability provision applied to the supposedly "follow form" excess policies.  At the time of binding, the broker furnished the insured a "binder" (in effect a policy summary without the actual policy wording) for what were labeled "follow form" excess policies.  The binder for the third and fourth layer excess policies referenced an "Inverted Warranty Endorsement as of Inception," which, when the policy was issued, turned out to be a broad, joint and several exclusion for all claims "arising out of" any "facts and circumstances of which any insured had knowledge as of inception" of the policy, and which a "reasonable person would suppose might afford valid grounds for a [covered] claim."

The "innocent" directors and officers first argued that the severability endorsement in the primary policy should be construed to apply to the follow-form excess policies despite the more restrictive exclusion in the excess.  That is, the excess policies followed form to the primary, except where the excess contained contradictory provisions, and here, the insureds argued, the policies could be construed consistently by permitting the more restrictive prior knowledge exclusion to apply only to the individual with the prior knowledge.  Judge Lynch disagreed, concluding that the more restrictive exclusion in the excess referenced the knowledge of "any insured" and was thus irreconcilable with the severability clause in the primary.  (Slip Op. at 28).  The Second Circuit concurred. (Summary Order p. 3)

Perhaps the stronger argument made by the "innocent" directors and officers in the District Court and on appeal, was that the excess insurers were precluded from relying on the inconsistent "prior knowledge" exclusion in the excess policy because they failed to put the insureds on notice of the conflicting exclusionary wording in the excess policy at the time the policy was issued.  However, Judge Lynch concluded that Refco had ample warning, quoting the binder reference to an "Inverted Warranty Endorsement," combined with correspondence between the broker and the excess insurers stating: "Refco prefers not to sign any warranties.  Should you need one to bind, please include an inverted warranty endorsement on your revised quote."  (Slip Op. at 29).  Again, the Second Circuit agreed.  (Summary Order p. 4).

Although the actual facts are unknown to this author, this may have been a situation in which Refco was cognizant of the implications of the insurers' request for a warranty of no knowledge of pending claims, and chose to avoid such a clear (and potentially false) warranty - opting instead for a less onerous prior knowledge exclusion.  Nevertheless, innocent directors and officers should never be exposed to this type of coverage gap - a strong argument for purchase of non-rescindable Side A DIC coverage or segregated Side A limits for independent directors.

Looking at this case from 30,000 feet instead of the ground level, the lessons here are fairly stark.  One, a policyholder should never agree to bind excess coverage without reviewing and understanding all of the terms and conditions that may vary from the primary.  Two, there is almost never a reason for the terms of an excess policy to vary materially from the primary - particularly on the wording of a critical exclusion such as for prior knowledge or pending claims.  And three, to add some lessons borne of recent experience in other cases, the excess policies should contain compatible dispute resolution clauses, to avoid having to litigate with the primary in New York and to arbitrate with one excess in London and another in Bermuda.

Peter M. Gillon, Pillsbury Winthrop Shaw Pittman, peter.gillon@pillsburylaw.com