D&O insurance policies often address a policyholder’s particular circumstances. One way that D&O insurers sometimes address the fact that a company has experienced adverse circumstances is to incorporate into its policy a “known circumstances exclusion” precluding coverage for those circumstances. In an October 23, 2013 opinion (here), the First Circuit affirmed the opinion of the lower court that a known circumstance exclusion in a non-profit D&O insurance policy precluded coverage for the underlying claim. Although the holding itself is unsurprising in light of the exclusion, the case does underscore the critical importance of the wording used in creating these kinds of exclusions.
The Clark School for Creative Learning is a non-profit educational institution located in Danvers, Massachusetts. The school faced financial difficulties, as it was running an operating deficit and its liabilities exceeded its assets. In May 2008, two parents of three of the school’s students (the Valentis) donated $500,000 to the school.
The school’s financial difficulties were disclosed at length in Note 8 to the school’s financial statements, which was entitled “Insufficient Net Assets.” Note 8 also referred to the Valentis’ gift:
Subsequent to the date of the accompanying financial statement, in May of 2008, the School was a recipient of a major gift totaling $500,000 (see footnote 7). The donation is unrestricted and will be used to support the School’s general operations as management’s plans for the School’s future are implemented and allowed time to succeed. Management feels that its plans and the subsequent major gift will enable the School to operate as a going concern.
The Valentis’ gift is further described in Note 7 of the school’s financial statements. Footnote 7 was entitled “Major Gift” and described the gift in detail.
In May 2009, the Valentis filed a lawsuit in Massachusetts state court against the school and its director alleging that the school had not followed through on alleged promises the school and the director allegedly made in soliciting the gift. The school eventually settled the Valentis’ lawsuit by agreeing to return a portion of the gift.
The school submitted the Valentis’ lawsuit as a claim under its D&O insurance policy. The insurance carrier denied coverage for the claim in reliance on an exclusion in the policy entitled “Known Circumstances Revealed in Financial Statement Exclusion.” The exclusion precluded coverage for any losses “in any way involving any matter, fact, or circumstance disclosed in connection with Note 8 of the [school’s] Financial Statement.”
The school initiated a lawsuit against the insurer seeking to have the insurer reimburse the school for the costs of defending and settling the Valentis’ lawsuit. The district court granted summary judgment in the insurer’s favor and the school appealed.
The October 23 Opinion
In an October 23, 2013 opinion written by Chief Judge Sandra Lynch for a unanimous three judge panel, the First Circuit affirmed the district court.
In her opinion, Judge Lynch observed that the known circumstance exclusion’s reference to Note 8 of the school’s financial statements is “both clear and broad,” that the exclusion precluded coverage for “any matter, fact, or circumstance disclosed in connection with Note 8 of the Financial Statement.” She added that
One matter, fact or circumstance disclosed in Note 8 is the Valentis’ gift, along with other information about the School’s troubled finances. And the loss and defense costs for which coverage is sought certainly “involve[es]” that gift, since the loss and costs were incurred in defending and settling litigation about the gift. The plain language of the Known Circumstances Exclusion excludes from coverage the losses from the suit brought by the Valentis about their gift.
The appellate court rejected the school’s argument that the exclusion was intended to apply only to the financial difficulties and going concern question discussed in Note 8, not to the Valentis gift, as well as the school’s argument that if the parties had intended for the exclusion to apply to the gift, the exclusion would have referenced Note 7. Judge Lynch said only that “the language here plainly is not limited to losses caused by financial difficulties,” adding that “the parties did reference Note 7: the discussion on the Valentis’ gift in Note 8 explicitly refers to Note 7.”
The appellate court also rejected the school’s argument that the application of the exclusion to preclude coverage deprives the school of coverage it reasonably expected. The school argued that it would not have expected the exclusion to reach the Valentis’ suit because the exclusion focused on the school’s financial difficulties and because the suit had not yet been filed and therefore could not have been a “known” circumstance.
In rejecting this argument, Judge Lynch said that “the footnote referred to the known circumstance of the gift and went further, describing the gift as unrestricted. The Valentis’ lawsuit alleged otherwise.” Judge Lynch added that “when a contract is not ambiguous, a party can have no reasonable expectation of coverage when that expectation would run counter to the unambiguous language of an insurance policy.”
At one level, the outcome of this insurance coverage dispute is unremarkable. The policy had an exclusion that precluded coverage for loss involving any circumstance mentioned in Note 8. Note 8 referred to the Valentis’ gift. The Valentis’ lawsuit related to the gift. Under those circumstances, the outcome is no surprise.
However, consider if you will the circumstances involved in the placement of this policy. The school was facing financial difficulties, which were fully documented in Note 8, which was titled “Insufficient Net Assets.” The financial difficulties described in Note 8 obviously would be a concern for a D&O insurance underwriter and the underwriter would want to take protective measures against problems arising from the school’s financial difficulties. Fortunately for the school, it had also received a major gift that potentially could allow the school to continue as a going concern. The gift was described in detail in Note 7, which was titled “Major Gift,” and mentioned in Note 8 in connection with the going concern issue. So the purpose of Note 8, titled “Insufficient Net Assets,” was to describe the school’s financial difficulties and possible relief, and the purpose of Note 7 was to describe the gift.
The reason the insurer added the Known Circumstances Exclusion was because of the school’s financial difficulties, described in Note 8. The insurer wouldn’t have been concerned about the gift as that was the school’s best hope to be able to carry on.
Unfortunately for school, the exclusion that was added referred generally to Note 8. It did not refer to the specific financials issues within Note 8. The exclusion was written broadly so that it encompassed all circumstances reference in Note 8, not just the references in Note 8 to the school’s financial difficulties.
I want to make it clear here that I am not finding fault in any way with the way the exclusion at issue was worded. I have no way of knowing the circumstances surrounding the placement of this policy nor do I have any way of knowing whether the insurer in any event would have agreed to a narrower wording; given the school’s financial difficulties, the insurer may not have been willing to agree to a narrower wording in any event.
Nevertheless, this case is a reminder of the critical importance of making sure that when coverage limiting exclusions are added, that they are worded as narrowly as possible. Given the school’s financial difficulties, it may have been unavoidable that the school’s insurance policy would preclude coverage for claims relating to those difficulties. But there is no reason that the exclusion should have been written so broadly that it also precluded coverage for matters that not only were not part of the school’s financial difficulties, but that at that time were among the reasons that the school might hope to be able to continue as a going concern.
When organizations have experienced adverse circumstances, it may not be possible for the organization to obtain D&O insurance without an exclusion precluding coverage for those circumstances. (Obviously it is always better to have a policy without the exclusion, but sometimes it is not possible to find coverage without an exclusion.) But if an exclusion is to be added, it should be tailored as narrowly as possible, to try to ensure that the exclusion is not applied to preclude coverage for matters outside the area of concern.