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 affirmed.


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 the exclusion.


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 carriers.


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 into 2012.


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 so far.