Michigan Court Holds Pollution Exclusion Applies to Emissions Permit Violation

In its recent decision in Arch Ins. Co. v. Commercial Steel Treating Corp., 2013 U.S. Dist. LEXIS 121574 (E.D. Mich. Aug. 27, 2013), the United States District Court for the Eastern District of Michigan had occasion to consider the application of a pollution exclusion in a D&O policy to a violation of an air emissions permit.

Arch insured Curtis Metal Finishing Company (“Curtis”) under a Private Company Management Liability and Crime Insurance policy.  Curtis operated a zinc-phosphate plating operation in Sterling Heights, Michigan.  As a result of a windstorm that damaged its exhaust equipment, Curtis operated its facility without the benefit of all required air emissions control technologies for a period of nearly three months, thereby violating its air use permit issued by the Michigan Department of Environmental Quality.  Following several inspections, the Michigan Department of Natural Resources and Environment (“MDNRE”) issued a Violation Notice to Curtis.   

Curtis forwarded a copy of the notice to Arch, and requested coverage for any subsequent criminal proceedings that might be brought by the state.  Arch, in turn, denied coverage based on a pollution exclusion arising from, based upon, or attributable to any:

a.   discharge, dispersal, release, escape, seepage, migration or disposal of Pollutants, . . . or any threat of such discharge, dispersal, release, escape, seepage, migration or disposal; or

b.   direction, request or voluntary decision to test for, abate, monitor, clean up, remove, contain, treat, detoxify or neutralize Pollutants . . . .

In fact, the Macomb County prosecutor later commenced criminal proceedings against Curtis, alleging a count for failure to report an equipment malfunction and a count for failure to comply with its emissions permit.  As a result of Arch’s denial of coverage, Curtis retained its own counsel and eventually negotiated a plea of no contest in return for payment of $90,000 to be used for an environmental study.  Arch later brought a coverage action against Curtis seeking a declaration that it had no coverage obligations with respect to the settlement or Curtis’ defense costs.

On motion for summary judgment, Arch argued that both subparagraphs of the pollution exclusion applied.  With respect to subparagraph b., Arch contended that the air use permit initially issued to Curtis was a “direction to … clean up … Pollutants,” and that the underlying criminal action, therefore, arose out of or was attributable to this direction.  Alternatively, Curtis argued that subparagraph a. of the exclusion was applicable since the underlying criminal action arose out of Curtis’ improper discharge of pollutants into the atmosphere.  Curtis, on the other hand, argued that the underlying complaint contained no allegation of a discharge of pollutants, and that because its facility is kept at a negative air pressure, any emissions would have been into its own building rather than into the atmosphere.  The court rejected Curtis’ argument, noting that the plain language of the exclusion applied to any discharge of pollutants, or any threatened discharge of pollutants, and that the exclusion did not specific the location of the discharge.   In other words, the court refused to read into the exclusion a distinction between traditional environmental pollution and indoor air pollution.

Curtis also argued that the underlying criminal action pertained to permitting violations and failure to disclose rather than a discharge of pollutants.   The court rejected this argument, finding that Curtis could not ignore purpose behind the permit:

The purpose of the Air Use Permit was to prevent the release of potentially hazardous fumes ... A direct result of Defendants' operation of Lines 11 and 14 without a functioning scrubber, in violation of the Air Use Permit, is the release of fumes from Lines 11 and 14 into the Sterling Heights facility. There is thus "significantly more than a remote connection" between Defendants' permit violations and the actual or threatened release of pollutants from Lines 11 and 14 … Furthermore, even if there was no threatened or actual release of pollutants from Lines 11 and 14, the criminal charges arise out of a direction or request from MDNRE, via the Air Use Permit, to abate potentially hazardous pollutants. Accordingly, both subparagraphs a. and b. of the Pollution Exclusion apply to bar the criminal charges against Defendants.

The court also rejected Curtis’ arguments that the amount of actual emissions from the facility was insignificant, explaining:

Whether any pollutants actually leaked is immaterial where Defendants have clearly violated their Air Use Permit, which directed Defendants to abate pollutants. The Pollution Exclusion expressly applies to such criminal charges. Plaintiff thus properly denied coverage for Defendants' claims under the Policy, and Plaintiff is entitled to summary declaratory judgment that the Policy does not apply to the underlying criminal matters.

While the court held that the pollution exclusion operated to preclude Curtis’ right to coverage, the court also agreed in passing that the $90,000 payment made by Curtis to settle the underlying matter – an amount to be used to conduct a study of a nearby lake – did not qualify as “loss” under the Arch policy, a term specifically defined to exclude fines.

Massachusetts Court Allows Consideration of Extrinsic Evidence

In its recent decision in BioChemics, Inc. v. AXIS Reinsurance Co., 2013 U.S. Dist. LEXIS 111218 (D. Mass. Aug. 7, 2013), the United States District Court for the District of Massachusetts had occasion to consider when an insurer is entitled to rely on extrinsic evidence for determining its duty to defend.

AXIS insured BioChemics under a claims made and reported directors and officers policy for the period November 13, 2011 to November 13, 2012.  BioChemics sought a defense in connection with an SEC enforcement action filed during the period the policy was in effect.  BioChemics also sought a defense for two SEC subpoenas issued by the SEC during the policy period.  AXIS, however, took the position that BioChemics was not entitled to coverage for these matters because they related back to a series of subpoenas served by the SEC prior to the policy’s date of inception, at a time when BioChemics was insured by a different carrier.   In support of its position, AXIS relied on a provision in its policy’s Limits of Liability section stating that:

All Claims, including all D&O Claims . . . arising from the same Wrongful Act . . . and all Interrelated Wrongful Acts shall be deemed one Claim and such Claim shall be deemed to be first made on the earlier date that: (1) any of the Claims is first made against an Insured under this Policy or any prior policy . . . .

Notably, the subpoenas served by the SEC both prior to and subsequent to the AXIS policy’s date of inception all had the same SEC matter identification and number.

BioChemics filed a declaratory judgment action and subsequently moved for summary judgment on the duty to defend before the commencement of discovery, asserting that the duty to defend is based solely on the complaint and the policy, and that as such, discovery was not necessary.  AXIS opposed the motion, asserting that at the very least, it was entitled to discovery into communications between BioChemics and the SEC so that it could confirm whether, in fact, the subpoenas served prior to its policy’s inception were interrelated with the subsequent subpoenas and the enforcement action, thus comprising a “single, ongoing claim” first made prior to the policy period.

The court acknowledged a line of cases cited by BioChemics standing for the proposition that insurers cannot rely on extrinsic evidence for the purpose of determining a duty to defend.  The court went on to note, however, that this line of cases does not apply to extrinsic facts that will not be litigated in the underlying matter.  The court further observed that in the context of claims made and reported policies, the rule against consideration of extrinsic facts cannot be rigidly applied since coverage issues such as the timing of the claim are unlikely to be alleged in the underlying complaint.  While the court acknowledged it a close question, it ultimately held that:

… an insurer may use extrinsic evidence to deny a duty to defend based on facts irrelevant to the merits of the underlying litigation, such as whether the claim was first made during the policy period, whether the insured party reported the claim to the insurer as required by the policy, or whether the underlying wrongful acts were related to prior wrongful acts.

As such, the court allowed AXIS to proceed with discovery into the interrelatedness issue, and denied BioChemics’ motion for summary judgment without prejudice.  The court further held that under Massachusetts law, AXIS was not required to provide BioChemics with a defense pending determination of the duty to defend issue.

Mississippi Court Holds D&O Policy Not Triggered By Real Estate Scheme

In its recent decision in State Farm Fire & Cas. Co. v. Anderson, 2013 U.S. Dist. LEXIS 57837 (S.D. Miss. Apr. 23, 2013), the United States District Court for the Southern District of Mississippi had occasion to consider coverage for an alleged fraudulent real estate scheme under a comprehensive condo policy containing business liability coverage and directors and officers coverages

State Farm insured the Harbor House Property Owners Association, Inc., a condo development located in Diamondhead, Mississippi.  The Harbor House development experienced significant property damage as a result of Hurricane Katrina.  It was alleged that one of the Association board of directors, Carl Joffe, used his board position to intentionally delay rebuilding efforts after the hurricane so as to cause a number of property owners to sell their properties to Mr. Joffe, or one of his associates.  These properties were later resold to Diamondhead Real Estate (“DRE”), a land developer.  As a result of these sales, DRE was able to appoint enough members to the Association board so as to take majority control of the board.  DRE, through these individual board members and Joffe, thereafter engaged in efforts to have the development rezoned for use as a casino.  Although these efforts ultimately were unsuccessful, the homeowners brought suit against Mr. Joffe and various members of DRE that had been appointed to the Association board.  The suit sought money damages from these individuals based on theories of they (1) committed oppressive and/or fraudulent activity and breached their common law duty of loyalty and fiduciary duty to the Association; (2) engaged in self-dealing; (3) served the interests of DRE, rather than the Association and its members; (4) acted in bad faith; (5) engaged in intentional misconduct and a knowing violation of the Association's charter document; and (6) committed illegal, oppressive, and/or fraudulent acts.

State Farm’s policy contained a business liability coverage similar in nature to a general liability policy.  The policy provided coverage for bodily injury or property damage resulting from an occurrence.  It also provided coverage for personal or advertising injury resulting from an occurrence.  The court readily agreed that the underlying lawsuit contained no allegations of any such categories of harm resulting from an occurrence.

The policy’s directors and officers coverage insured the Association board for sums it became “legally obligated to pay as damages, because of ‘wrongful acts’ committed by an insured solely in the conduct of their management responsibilities for the Condominium/Association.”  The policy, however, contained an exclusion applicable to “any dishonest, fraudulent, criminal or malicious act” as well as an exclusion applicable to “damages arising out of any transaction of the insured from which the insured will gain any personal profit or advantage which is not shared equitably by the Condominium/Association members.” 

Joffe and the other board member defendants argued that coverage was triggered simply based on allegations of breach of fiduciary duty and breach of duty of care, and that the underlying complaint could be characterized as a negligence claim for which State Farm had a duty to defend and indemnify.  The court disagreed with the insureds’ characterizations, concluding that the underlying complaint alleged illegal, oppressive and/or fraudulent misconduct falling within the policy’s exclusions.  As the court explained:

The breaches alleged in the underlying case are not the sort of errors, omissions, or negligent acts covered by Option DO. They fall squarely within the coverage exclusions for "dishonest, fraudulent, criminal or malicious" acts, and "damages arising out of any transaction of the insured from which the insured will gain any personal profit or advantage which is not shared equitably by the Condominium/Association members." Therefore, the optional Directors and Officers Liability section does not provide coverage  for the conduct alleged in the underlying case.

Michigan Court Holds Contract Exclusion Applicable

In its recent decision in Certified Restoration Drycleaning Network v. Fed. Ins. Co., 2013 U.S. Dist. LEXIS 54457 (E.D. Mich. Apr. 16, 2013), the United States District Court for the Eastern District of Michigan had occasion to consider the application of a breach of contract exclusion to a dispute arising out of an alleged breach of a franchise agreement.

The insured, CRDN, franchised textile and dry cleaning systems throughout North America.  In 2007, it entered into an agreement with East Coast Garment Restoration, pursuant to which East Coast was required to pay a $11,000 franchise fee.  A year later, however, CRDN terminated the franchise relationship on the basis of information it learned from a background check of East Coast’s principal.  East Coast thereafter brought suit, and later an arbitration proceeding, against CRDN, alleging causes of action for breach of contract and breach of duty of good faith and fair dealing. 

Federal Insurance Company insured CRDN under a combined directors and officers, employment liability, fiduciary liability and insured organization coverage policy.  Federal’s policy obligated it to defend CRDN in connection with claims for wrongful acts.  The policy, however, contained an exclusion barring coverage for claims:

… based upon, or arising from, or in consequence of any actual or alleged liability of an Insured Organization under any written or oral contract or agreement, provided that this Exclusion … shall not apply to the extent that an Insured Organization would have been liable in the absence of the contract or agreement.

Federal denied coverage on the basis of this exclusion, contending that East Coast’s claim against CRDN arose solely out of the franchise agreement and CRDN’s alleged breach of this agreement.  CRDN, however, argued that notwithstanding the stated causes of action, certain assertions in the underlying proceeding could be interpreted as alleging misrepresentations made prior to the time that East Coast and CRDN entered into the franchise agreement.  CRDN also argued that there was no contractual relationship between it and East Coast.

While the court agreed that under Michigan law, it is not the “nomenclature” of the underlying claim, but instead the cause of injury that determines a duty to defend, the court agreed that East Coast’s claim arose wholly out of an alleged breach of franchise agreement.  Specifically, the underlying complaint alleged in detail CRDN’s efforts to induce East Coast to become a franchisee, the representations CRDN made concerning expected earnings, and CRDN’s decision to terminate the franchise agreement.  Further, the underlying complaint alleged that CRDN’s decision to terminate the franchise agreement was not on a ground permissible under the agreement.  Given these assertions, the court agreed that the exclusion applied, reasoning that the East Coast’s claim arose out of CRDN’s alleged breach of the franchise agreement, and that any references to “representations” were “a small part of the background story,” and did not change the nature of the underlying pleading.

In holding that the exclusion applied to bar coverage, the court considered and rejected CRDN’s argument that the exclusion did not apply because the underlying settlement agreement between CRDN and East Coast made reference to CRDN having made misrepresentations to East Coast.  CRDN argued that it was only upon drafting the settlement agreement that the parties determined that the “true nature” of East Coast’s claim was for misrepresentation rather than breach of contract.  The court found this argument “not realistic,” and that in any event, Federal’s duty to defend was determined based only on the allegations in the complaint rather than the language of the settlement agreement. 

New York Court Holds Professional Services Exclusion Applicable

In its recent decision in David Lerner Assocs. v. Philadelphia Indem. Ins. Co., 2013 U.S. Dist. LEXIS 46333 (E.D.N.Y. Mar. 29, 2013), the United States District Court for the Eastern District of New York had occasion to consider the application of a professional services exclusion in a directors and officers policy.

Philadelphia Indemnity Insurance Company insured David Lerner Associates, Inc. (“DLA”) under a Private Company Protection Plus Insurance Policy.  During the policy period, DLA was named as a defendant by FINRA in a disciplinary proceeding that alleged DLA had sold shares in a REIT without performing adequate due diligence and that DLA also misrepresented the value of the shares.  The complaint also alleged that DLA targeted its sales to senior citizens and/or unsophisticated investors.  DLA was later named as a defendant in three class actions relating to the same facts as alleged in the FINRA proceeding.

Philadelphia’s policy insured DLA against D&O Wrongful Acts, defined as:

1.   act, error, omission, misstatement, misleading statement, neglect, or breach of duty committed or attempted by an Individual Insured in his/her capacity as an Individual Insured; or

2.   act, error, omission, misstatement, misleading statement, neglect, or breach of duty committed or attempted by the Private Company; or

3.   act, error, omission, misstatement, misleading statement, neglect, or breach of duty committed or attempted by an Individual Insured arising out of serving in his/her capacity as director,  officer, governor or trustee of an Outside Entity if such service is at the written request or direction of the Private Company.

The policy, however, contained a professional services exclusion stating:

… the Underwriter shall not be liable to make any payment for Loss in connection with any Claim made against the Insured based upon, arising out of, directly or indirectly resulting from or in consequence of, or in any way involving the Insured's performance of or failure to perform professional services for others.

It is provided, however, that the foregoing shall not be applicable to any derivative action or shareholder class action Claim alleging failure to supervise those who performed or failed to perform such professional services.

The term “professional services” was not defined in the policy.

DLA denied coverage to DLA on the basis of this exclusion, prompting DLA to bring a declaratory judgment action.  Philadelphia moved to dismiss the complaint on the basis of the professional services exclusion, arguing that the allegations in the underlying complaints pertained to DLA’s failure to identify “red flags” regarding the REIT and that it failed to exercise due care and skill in providing information to its investors.  These allegations, argued Philadelphia, necessarily pertained to the provision, or lack thereof, of professional services under New York law.  DLA, on the other hand, argued that because the term “professional services” was not defined in the policy, it was an ambiguous term that, at the very least, precluded dismissal under Fed.R.Civ.P. 12(b)(6).

In considering these arguments, the court looked to the long line of New York decisions setting forth the standard that whether one is engaged in a professional service depends on whether that individual acted with a special degree of acumen and training.  The court further observed that under New York law, the term “professional services” is not limited to “traditional” professions such as lawyers, doctors, architects and engineers.  Against the backdrop of these cases, the court concluded that underlying claims pertained to DLA’s professional services:

… it is clear that the only reasonable interpretation of "professional services" is that individuals engaged in the due diligence and sale of financial products are engaged in professional services. According to the underlying complaints, DLA was an underwriter for Apple REITs.  It was required to conduct due diligence for these products, including performing financial analysis and meeting with Apple REIT management. DLA then recommended and sold over $442 million of this security. These actions, allegedly taken by DLA and individuals within the company, fall squarely within a common-sense understanding of “professional services.”

The court further noted that case law from other jurisdictions, such as Minnesota and Arizona, would require a similar determination. 

In reaching its conclusion, the court considered and rejected DLA’s argument that it was merely performing ministerial tasks that did not rise to the level of professional services, explaining that “performing a due diligence analysis and marketing financial products requires specialized knowledge and training, and is not a rote activity performed by a professional.”  The court further rejected DLA’s assertion that discovery should be allowed to proceed on the issue of whether it was performing professional services, noting that the allegations in the underlying claims contained sufficiently clear allegations from which to conclude the issue.

7th Circuit Addresses Insured vs. Insured Exclusion

In its recent decision in Miller v. St. Paul Mercury Ins. Co., 2012 U.S. App. LEXIS 13298 (7^th Cir. June 29, 2012), the United States Court of Appeals for the Seventh Circuit, addressing Illinois law, had occasion to consider the application of an insured vs. insured exclusion in a D&O policy.

St. Paul’s insured, Strategic Capital Bancorp, Inc. (“SCBI”), was sued by five plaintiffs for alleged fraud, civil conspiracy, and violation of the Illinois Consumer Fraud and Deceptive Business Practices Act.  Of these plaintiffs, three qualified as “insureds” under the St. Paul policy as former directors of SCBI.  The other two plaintiffs were never directors or officers of SCBI, nor did they otherwise qualify as insureds.  St. Paul denied coverage to SCBI for the lawsuit on the basis of an insured vs. insured exclusion barring coverage for “Loss on account of any Claim made against any Insured : … brought or maintained by or on behalf of any Insured or Company in any capacity … .”  On motion to dismiss, the United States District Court for the Central District of Illinois held in favor of St. Paul.

On appeal, the Seventh Circuit noted that insured vs. insured exclusions are standard in D&O policies and that were the underlying suit brought solely by former SCBI directors, the exclusion would operate to bar coverage.  Alternatively, were the underlying suit brought solely by non-insureds, it would not apply.  The dilemma presented to the court, therefore, was “how to apply the policy when insured and non-insured plaintiffs join their individual claims in one lawsuit.”

The court identified three potential ways to resolve this question.  The first would be that as long as at least one non-insured plaintiff is not part of the lawsuit, then the exclusion is inapplicable.  The court acknowledged that this “rule would produce arbitrary results depending on whether insured plaintiffs did or did not have a non-insured plaintiff join in the same lawsuit.”  Moreover, this rule “would also make it easy for insured plaintiffs to evade the terms and purposes of the insured vs. insured exclusion by recruiting just one non-insured plaintiff to join an otherwise collusive or intramural lawsuit.”  The second alternative, proposed by St. Paul, would be that the presence of one insured plaintiff voids coverage for the entire lawsuit, regardless of how many non-insured plaintiffs were in the lawsuit.  St. Paul, at oral argument, conceded that under this rule if a lawsuit is brought by ninety-nine non-insured plaintiffs, and just a single insured plaintiff, then coverage would be unavailable.  The court found this proposed resolution unavailing as well, explaining that it too invited “arbitrary results depending on whether many people with similar claims file one consolidated lawsuit or many separate lawsuits.”

In light of the arbitrariness of these two potential approaches, the court revisited its reasoning as set forth in Level 3 Communications, Inc. v. Federal Ins. Co., 168 F.3d 956 (7^th Cir. 1999), wherein the court required an allocation of indemnity and defense costs for a lawsuit brought by both insured and non-insured plaintiffs.  The Millercourt found that this approach:

… minimizes the risk of arbitrary results and discourages efforts to manipulate the result by the ways in which individual claims happen to be combined or separated. This answer also has the advantage of conforming to the parties' reasonable expectations: the insurer owes no duty to indemnify for claims brought by insured plaintiffs but does owe that duty for claims brought by others.

The court observed that the St. Paul policy, similar to the policy in Level 3, required allocation of defense and indemnity costs between covered and non-covered claims.  A lawsuit brought by insureds and non-insureds, explained the court, presents a claim “that includes both covered and uncovered matters, depending on the status of the different plaintiffs” and thus, under the reasoning in Level 3, St. Paul owed a coverage obligation to SCBI for the claims brought by non-insureds, but not for those brought by insureds.

St. Paul argued that Level 3 was distinguishable on several grounds, none of which were persuasive to the court.  First, St. Paul argued that in Level 3, the insured plaintiff did not join the underlying suit until well after it had been filed.  The court, however, concluded that issues of timing, and which plaintiffs are part of the original pleading, are not valid considerations under Level 3.  St. Paul also advocated for a “majority” rule, under which the insured vs. insured exclusion would apply to an entire suit if the damages claimed by insured plaintiffs outweighed those claimed by non-insured plaintiffs.  The court rejected this theory as well, explaining that:

This proposed additional requirement for a majority of non-insured claimants or dollars has no basis in the St. Paul policy language. It would also invite similarly arbitrary results, depending again on whether insured and non-insured plaintiffs filed separate or joint complaints. What would happen if one or more plaintiffs settled so as to shift the balance one way or the other? And should the relevant majority be the number of claimants or the number of dollars? By contrast, the allocation provision in the St. Paul policy gives us a fairly clear answer: coverage is not all-or-nothing based on one of these (perhaps unstable) majorities. Coverage is allocated based on "the relative legal exposure of the parties to covered and uncovered matters."

Finally, St. Paul argued that certain exceptions to the insured vs. insured exclusion as stated in the policy, by negative implication, operated to bar coverage of an entire claim when it includes the “active” participation of any insured plaintiff, regardless of whether the other plaintiffs are insured or not.  The court rejected this argument as well, finding that the “exceptions provide no guidance on how to treat claims by non-insured plaintiffs who were never subject to the exclusion.” 

Pennsylvania Court Considers Coverage for Gerry Sandusky Under D&O Policy

In its recent decision in Federal Ins. Co. v. Sandusky, 2012 U.S. Dist. LEXIS 76880 (M.D. Pa. June 4, 2012), the United States District Court for the Middle District of Pennsylvania had occasion to consider whether a D&O insurer was required to defend an employee of the insured in connection with underlying criminal and civil matters arising out of alleged molestation of children.

Federal Insurance Company issued a directors and officers and employment practices policy to The Second Mile, a charitable organization founded in part by Gerry Sandusky, who has received great notoriety for having allegedly molested numerous children both during and after his time as a coach for the Penn State football team.  Following a grand jury investigation, Sandusky was charged with forty criminal counts, including sexual assault and unlawful contact with a minor.  Sandusky and The Second Mile were also named as defendants in a civil suit filed in Pennsylvania.  Sandusky sought coverage under the Federal policy, and Federal advanced Sandusky’s criminal attorney $125,000 in legal fees, subject to a reservation of rights.  Federal thereafter filed a declaratory judgment action.

Federal agreed that Sandusky qualified as an insured person under the policy.  It nevertheless sought a declaration that Sandusky was not entitled to coverage for the underlying criminal and civil matters because he was not acting in an insured capacity as an employee or executive of The Second Mile when he committed the alleged acts.  Federal also contended that the policy’s D&O coverage excluded bodily injury, willful statutory violations and sexual harassment.  Prior to commencing discovery, however, Federal moved for judgment on the pleadings, arguing that “were The Second Mile’s insurance policy ultimately interpreted to cover losses stemming from the allegations of sexual abuse and molestation of minors, the insurance policy would be void as against Pennsylvania’s public policy.”  Thus, before addressing the coverage issues stemming from the policy, Federal sought a judgment based solely on public policy grounds.

The court acknowledged that “[s]exual abuse and molestation of children are ‘so obviously … against the public health, safety, morals or welfare that there is a virtual unanimity of opinion with regard to it.”  This unanimity of opinion, explained the court, is reflected in numerous Pennsylvania laws concerning the safety of children.  The court further observed that “public policy bars enforcement of insurance contracts that indemnify insured persons for damages arising from reprehensible conduct.”  Given these factors, the court determined that Pennsylvania would deem unenforceable, as a matter of law, any contract indemnifying the perpetrator of intentional sexual molestation of children.  As the court explained:

Such a contract would allow an insured to shift the consequences of intentional, reprehensible conduct to an insurance company, thereby abdicating personal responsibility. It is entirely clear, and this Court holds, that the public policy of Pennsylvania as announced by its courts prohibits the reimbursement of Sandusky for any damage award that he may ultimately be found to owe arising from the allegations that he molested and sexually abused children.

While the court concluded that Sandusky was not entitled to indemnification for the alleged conduct, it nevertheless struggled with the issue of whether he was entitled to a defense.  The court noted that the issue of whether providing a defense in a sexual molestation case violates public policy was one of first impression under Pennsylvania law.  The court acknowledged that general rule that there can be no duty to defend allegations that are not potentially covered, but explained that “where, as here, an insurance policy specifically includes defense costs as covered loss, separate and apart from damages, the mechanical process of determining whether there could be coverage for damages in order to determine whether there is a duty to defend cannot be applied.”

Ultimately, the court avoided ruling on the issue of defense costs, explaining that “[w]ithout the benefit of a factual record, it is not entirely clear that Pennsylvania's public policy would prohibit enforcement of the insurance policy to the extent that it provides Sandusky with defense costs.”  The court specifically concluded that further development of facts through discovery could bear on the issue of the court’s public policy determination, such as whether Sandusky himself purchased the Federal policy and did so knowing that criminal charges were imminent.

New York Court Rejects $90 Million D&O Settlement

In In re Lehman Brothers Securities and ERISA Litigation, 2012 U.S. Dist. LEXIS 65167 (S.D.N.Y. May 3, 2012), Judge Lewis A. Kaplan, for the United States District Court for the Southern District of New York considered the reasonableness of a settlement between various former Lehman Brothers directors and officers and their insurers.

Beginning his opinion with a reference to Kenny Rogers’ The Gambler, Judge Kaplan observed that when it comes to litigation, one must know when to hold ‘em and when to fold ‘em.  In the context of a class action, he noted, a court must act as the surrogate for the plaintiff class in determining whether a settlement is reasonable, and as such, it fell on him to determine whether to allow the parties “to fold ‘em.”

The class action in In re Lehman Brotherswas brought on behalf of investors that had purchased or otherwise held Lehman Brothers securities.  Because Lehman Brothers is in bankruptcy, the defendants were former individual officers and directors and directors of the company.  Before Judge Kaplan was a $90 million settlement between these directors and officers and Lehman Brothers’ insurer, which would be paid to the plaintiff class.  If approved, all claims against the directors and officers would be released, with these individuals paying no amounts from their own pockets.

Lehman Brothers originally had $250 million in available insurance limits.  As a result of defense costs, however, this amount had been reduced to $180 million by the end of 2010.  The insurer took the position that it would contribute to a settlement only on the condition that it resolved all claims against the individual defendants.  The individual defendants took the position that they would not contribute any amounts toward a settlement other than through available insurance funds.  In other words, they would not pay any amounts out of their own pockets.  Notwithstanding, the individual defendants agreed to hire a consultant, a retired judge, to determine whether their combined “liquid” and certain limited “non-liquid” assets exceeded $100 million.  The consultant concluded that these assets were indeed less than $100 million.

With this background in mind, Judge Kaplan considered whether a $90 million settlement was reasonable under the circumstances.  He acknowledged that if the settlement was not approved, the available insurance funds likely would be erode rapidly through payment of defense costs in the various lawsuits pending against Lehman Brothers and their directors and officers.  Should that happen, the directors and officers would be forced to rely on their individual assets, whether liquid or illiquid, to defend and/or settle the litigations.  The amount sought in these suits, he observed, could easily reach billions of dollars.  Judge Kaplan observed that looking only to the individual defendants’ liquid assets did “not permit the Court fully to consider the factors pertinent to approving or rejecting the settlement,” nor was the asset inquiry “as informative as necessary and appropriate for this Court” to consider the reasonableness of the settlement.  Accordingly, Judge Kaplan directed that further inquiry be had into the entirety of the individual defendants assets, liquid and non-liquid, so that the court could determine the reasonableness of the settlement.

7th Circuit Holds No Coverage for Restitution Claim Under D&O Policy

In its recent decision in Ryerson Inc. v. Federal Ins. Co., 2102 U.S. App. LEXIS 7372 (Apr. 12, 2012), the United States Court of Appeals for the Seventh Circuit, applying Illinois law, had occasion to consider whether an underlying suit seeking rescission of a fraudulent transaction triggered coverage under a directors and officers liability policy.

The underlying facts in Ryerson involved the insured’s allegedly fraudulent sale of a number of subsidiaries to EMC Group.  EMC later sued Ryerson, seeking rescission of the sale and restitution of the purchase price on the theory that Ryerson withheld certain material information concerning one of the subsidiaries.  EMC claimed that Ryerson fraudulently concealed this information in an effort to induce the sale.  EMC also alleged causes of action for breach of contract and breach of warranty.  Federal Insurance Company denied coverage to Ryerson, and Ryerson subsequently settled the matter with EMC for $8.5 million.

Federal’s policy provided coverage for “all LOSS for which [the insured] becomes legally obligated to pay on account of any CLAIM … for a WRONGFUL ACT … .”  Federal argued that “loss” does not and cannot include restitution.  The court agreed, stating that allowing coverage for such claims would, in essence, encourage fraud.  Citing to a number of cases, including its seminal decision in Level 3 Communications, Inc. v. Federal Ins. Co., 272 F.3d 908 (7^th Cir. 2001), the court explained that:

If disgorging [the proceeds of ill-gotten gains] is included within the policy’s definition of “loss,” thieves could buy insurance against having to return money they stole.  No one writes such insurance.

The court further explained that regardless of whether the for restitution claim is based on fraud or an innocent mistake is of no consequence.  Rather, the key determination is whether the claim is for compensatory damages or for return of “something that belongs of right not to [the defendant] but to the plaintiff.”  As such, the court noted, it was not a relevant consideration that EMC styled its complaint as one for damages:

EMC was seeking to recover a profit made at its expense by Ryerson’s fraud, which means that if the insurance company were liable to Ryerson, Ryerson would get to keep profits of fraud.  Having to surrender those profits was not a “loss” to Ryerson within the meaning of the insurance policy … .

The court acknowledged that in some instances, a judgment or settlement in a fraud case can include a combination of restitution and damages, the latter of which may be covered.  For instance, the EMC complaint initially sought recovery “transaction costs,” which the court agreed “would not be restitution because Ryerson gained nothing from the money that EMC paid its lawyers and accountants to handle the acquisition [of the subsidiary group].”  The court nevertheless concluded that because the underlying settlement made no effort to allocate as between restitution and such transaction costs, Ryerson forfeited any right it may have had for such amounts.

Virginia Federal Court Grants Summary Judgment In Favor of D&O Insurer

In its recent decision in Farkas v. Nat'l Union Fire Ins. Co., 2012 U.S. Dist. LEXIS 38696 (E.D. Va. Mar 21, 2012), the United States District Court for the Eastern District of Virginia had occasion to consider the application of exclusions in a directors and officers policy barring coverage for wrongful gains and fraudulent conduct if proven “in fact.”

An individual insured – the chairman and majority shareholder of the insured entity – was indicted for multiple counts of committing and conspiring to commit bank, wire, and securities fraud.  He sought coverage under the D&O policy issued by National Union.  National Union agreed to advance defense costs in the criminal proceeding, subject to a reservation of rights on the following policy exclusions:

The Insurer shall not be liable to make any payment for Loss in connection with a Claim made against an insured: [4(a)] arising out of, based upon or attributable to the gaining in fact of any profit or advantage to which an Insured was not legally entitled; [and] . . . [4(c)] arising out of, based upon or attributable to the committing in fact of any criminal, fraudulent or dishonest act, or any willful violation of any statute, rule or law.

A criminal trial resulted in the insured being convicted of sixteen counts of fraud and conspiracy to commit fraud.  National Union subsequently disclaimed coverage on the two policy exclusions, contending that the conviction proved “in fact” that the insured had gained a profit to which he was not legally entitled and that he had committed fraudulent or dishonest acts.  In the subsequent coverage action, National Union sought a declaration that not only did the exclusions apply, but that it was entitled to recoup defense costs already advanced.

The insured argued that the exclusions were ambiguous as to when they apply, and were  thus unenforceable.  The court rejected this argument, noting that the majority of courts to have considered similar “in fact” exclusions have ruled that “some pertinent factual finding” is all that is necessary to trigger these types of exclusions, and that the underlying criminal conviction, resulting from a jury trial, satisfied this requirement.  Moreover, the court rejected the insured’s argument that the potential for a reversal on appeal precluded a finding in National Union’s favor, noting that there was no case law to support such an interpretation of the “in fact” language.  The court also noted that “in fact” language, as opposed to similar exclusions only requiring a “final adjudication,” gives the insurer insurer the option to obtain a finding “in fact” in a declaratory judgment action or to rely on the outcome of the underlying action.

The court further found that in light of the finding that the policy exclusions applied, National Union was entitled to recoup defense costs already paid, since the policy contained a provision stating that “advanced payments by the Insurer shall be repaid to the Insurer by the Insureds or the Company, severally according to their respective interests, in the event and to the extent that the Insureds or the Company shall not be entitled under the terms and conditions of this policy to payment of such Loss.”

Texas Court Considers Prior Knowledge Condition In D&O Policy

In the recent decision in Deer Oaks Office Park Owners Ass'n v. State Farm Lloyds, 2012 U.S. Dist. LEXIS 19240 (W.D. Tex. Feb. 15, 2012), the United States District Court for the Western District of Texas had occasion to consider a prior knowledge condition in a directors and officers liability policy.

The insured, Office Park, was “an office park condo association which owns, maintains and regulates the 'common areas' between fifteen unconnected office condos” in San Antonio, Texas.  In 2007, it sold one of the condominium units to a doctor who intended to convert the unit for use in his medical practice.  The doctor advised that being able to install an elevator into the unit was an important aspect and condition of his purchase.  After the sale, however, the doctor was unable to obtain a permission from building maintenance to install the elevator.  He subsequently complained to Office Park, and later commenced a lawsuit in Texas state court.

Office Park sought coverage for the suit under the directors and officers coverage of its policy with State Farm Lloyds, effective for claims first made during the period January 30, 2010 to January 30, 2011, which encompassed the period in which the doctor commenced suit.  The policy’s insuring agreement stated that coverage “applies to 'wrongful acts' committed before this optional coverage became effective if the insured had no knowledge of a claim or suit at the effective date of this option and there is no other applicable insurance.”  State Farm Lloyds denied coverage for the suit on the basis that Office Park had knowledge of the doctor’s claim prior to the policy’s inception.  Specifically, State Farm Lloyds relied on a September 23, 2009 letter from the doctor’s attorney that “traced [the doctor’s] multiple complaints about Office Park and attributed monetary losses to Office Park.”  

Office Park argued that the doctor’s letter did not constitute a “claim” or notice of a “claim,” because the letter did not specifically demand any monetary relief.  In support of its position, Office Park pointed out that the State Farm Lloyds policy did not contain a definition of the term “claim,” and that as such, under the Fifth Circuit decision in Int'l Ins. Co. v. RSR Corp., 426 F.3d 281 (5th Cir. 2005), the term “claim” must be narrowly construed as “a demand for money, property, or legal remedy.” Office Park contended that because the doctor’s September 23, 2009 letter did not actually seek monetary relief, it could not constitute a “claim” for the purpose of the policy’s “knowledge of a claim or suit” condition to coverage.

The court disagreed with Office Park’s restrictive reading of RSR Corp., finding that the term “claim” is not limited solely to demands for monetary relief, but instead encompasses any assertion of a legal right.  Such an interpretation, the court explained, ordinarily is favorable to the insured, rather than the insurer, “because the construction gives the insured the right to seek coverage without waiting for the filing of a lawsuit.”  The court went on to conclude that the doctor’s letter qualified as a “claim” because it clearly stated a legal demand for relief and advised of the potential for litigation should an accommodation not be made.  As the court explained:

The only reasonable interpretation of the letter is that [the doctor] asserted a right to hold Office Park liable for all of the costs [he] had spent and lost because of Office Park's acts. The letter's bottom line was: If you do not comply with my demands, I will sue you. Under any construction, the letter constituted a claim.

As such, the court concluded that State Farm Lloyd’s denial of coverage was correct and that it had no duty to defend or indemnify the doctor in connection with the underlying matter.

California Court Holds Professional Services Exclusion Ambiguous

In its recent decision in Corky McMillin Construction Services, Inc. v. U.S. Specialty Ins. Co., 2012 U.S. Dist. LEXIS 3438 (S.D. Cal. Jan. 11, 2012), the United States District Court for the Southern District of California considered the application of an errors and omissions exclusion contained in a directors and officers insurance policy.

At issue in Corky McMillin was the insured’s right to coverage for an underlying class action.  Plaintiffs in the suit alleged that the insured, Corky McMillin, made various misrepresentations and omissions regarding the nature, value and desirability of certain residential neighborhoods. The policy provided coverage for “Insured Organization Loss arising from Claims first made against [the insured] during the Policy Period or Discovery Period (if applicable) for Wrongful Acts.” By endorsement, however, the policy contained an errors and omissions exclusion, stating in relevant part that:

… the Insurer will not be liable to make any payment of Loss in connection with any Claim against the Insured Organization arising out of, based upon or attributable to the rendering or failure to render services for others, including without limitation services performed for or on behalf of customers or clients of the Insured Organization … .

U.S. Specialty denied coverage on the basis of this E&O exclusion. Corky McMillin argued that the exclusion was ambiguous since the term “services” was not defined in the policy. U.S. Specialty countered, and the court agreed, that the term “services” should be interpreted based on its common dictionary definition, meaning “the work performed by one that serves.” The court further agreed with U.S. Specialty that while this definition of “services” was broad, the mere breadth of the term did not otherwise render it ambiguous.

The court nevertheless found the exclusion as a whole to be ambiguous when considered in the context of the policy’s insuring agreement, which provided coverage for “wrongful acts,” defined in pertinent part as “any other actual or alleged act, error, misstatement, misleading statement, omission or breach of duty (a) by the Insured Organization … .” The court noted that while the intent of the E&O exclusion was to bar coverage for liability arising out of the insured’s services, it was not clear whether “services,” with its broad meaning, encompassed, and therefore excluded, the same “wrongful acts” covered under the policy’s insuring agreement.  For instance, explained the court, while the definition of “wrongful act” included misstatements, misleading statements and omissions, the exclusion, on its face, would operate to bar coverage for misstatements, misleading statements and omissions contained in the insured’s marketing materials – the very basis on which the insured was sued in the underlying suit. Given the “canons of construction” that insuring agreements are to be interpreted broadly in favor of the insured and that exclusions are to be interpreted narrowly against the insurer, the court concluded that “there is, at a minimum, ambiguity about the meaning of the term ‘services’ as used in the E&O Endorsement.”

Eleventh Circuit Affirms Regulatory Investigation Not a Claim Under D&O Policies

In its recent decision in Office Depot, Inc. v. Nat'l Union Fire Ins. Co., 2011 U.S. App. LEXIS 20759 (11^th Cir. Oct. 13, 2011), the Eleventh Circuit Court of Appeals, applying Florida law, affirmed a lower court decision finding that Office Depot was not entitled to coverage under a primary and excess “organization insurance” policy for attorneys’ fees associated with an SEC investigation.

In July 2007, Office Depot gave notice to its insurers of an article from the Dow Jones Newswire reporting that Office Depot may have violated federal securities laws by selectively disclosing nonpublic information.  A week later, the SEC sent a letter to Office Depot advising that it would be undertaking an investigation into whether Office Depot had, in fact, violated federal securities laws.  A few weeks later, the SEC informally asked Office Depot to produce various communications relevant to its investigation. It was not until January 2008, however, that the SEC issued a formal order of investigation.  This investigation lasted over two years, and included subpoenas being issued to various Office Depot directors and officers, and  Wells Notices being issued.  In December 2009, the SEC filed a formal complaint and the matter was later settled.  At issue before the Eleventh Circuit was whether Office Depot was entitled to coverage for its attorneys’ fees associated with the SEC investigation during the period between the first letter in July 2007 and the issuance of the formal subpoenas and Wells Notices.

Office Depot argued, among other things, that its policies provided coverage for all defense costs incurred following its receipt of the SEC notice in July 2007, i.e., for the SEC’s informal investigation.  The policies’ insuring agreement applicable to organization insurance provided coverage for:

(i) Organization Liability. This policy shall pay the Loss of any Organization arising from a Securities Claim made against such Organization for any Wrongful Act of such Organization. . . .

Securities Claim was defined by the policies as:

…a Claim, other than an administrative or regulatory proceeding against, or investigation of an Organization, made against any Insured:

    (1)   alleging a violation of any federal, state, local or foreign regulation, rule or statute regulating securities . . .; or

    (2)   brought derivatively on the behalf of an Organization by a security holder of such Organization.

Notwithstanding the foregoing, the term "Securities Claim" shall include an administrative or regulatory proceeding against an Organization, but only if and only during the time such proceeding is also commenced and continuously maintained against an Insured Person.  (Emphasis supplied.)

Office Depot contended that it was entitled to defense costs dating back to the SEC’s July 2007 letter because the definition of Securities Claim did not expressly exclude informal SEC investigations.  Office Depot further argued that the carve-back provision of the definition of Securities Claim brought back into coverage an “administrative or regulatory proceeding.”

The Eleventh Circuit disagreed, explaining that the initial portion of the definition of Securities Claim, through the use of the disjunctive term “or,” eliminated coverage for two types of potential Securities Claims: those involving administrative or regulatory proceedings and those involving administrative or regulatory investigations.  The court determined that while the carve-back portion of the definition of Securities Claims gave back coverage for administrative or regulatory proceedings under certain circumstances, it did not restore coverage for investigations.  Thus, concluding that the SEC’s July 2007 was an investigation, the court held that Office Depot was not entitled to coverage for attorneys’ fees associated with responding to same.  It was not until the SEC issued subpoenas and Wells Notices to covered individuals that that the policies’ coverage was triggered.

The court considered several secondary arguments raised by Office Depot, most notably its argument that the policies’ notice provision operated to bring defense costs back into coverage.  This provision stated, in pertinent part, that if during the policy period Office Depot gave notice of circumstances that might result in a claim, then any future claim would be considered made at the time notice of circumstances was given.  Office Depot argued that by providing notice of the Dow Jones article to its insurers, it gave notice of circumstances, such that when the Claim was later made, “any costs incurred between the notice of circumstances and the date a Claim was made” was brought back into coverage.  The court rejected this bootstrapping argument, explaining that the notice of circumstances provision serves only to bookmark coverage under the policies for when a Claim is later made, even if outside the policy period, and does not operate to bring into coverage pre-Claim defense costs, particularly those relating to a non-covered regulatory investigation.