In a decision that gives broad effect to a D&O insurance policy’s contractual liability exclusion, on August 17, 2012, Middle District of Pennsylvania Judge William Nealon granted the insurer’s motion for summary judgment, holding under Pennsylvania law that the insurer had no obligation to defend or indemnify the policyholder in the underlying action. A copy of Judge Nealon’s opinion can be found here.



In 2004 and 2005, Uni-Marts sold a group of convenience stores in Pennsylvania. The buyers later contended that Uni-Marts had made misrepresentations and omissions about costs and expenses to induce prospective buyers. The buyers initiated a lawsuit in Pennsylvania state court against UniMarts (referred to as the Alliance Action). The complaint in the Alliance Action contained five causes of action against Uni-Marts: 1) fraud in the inducement; 2) negligent misrepresentation; 3) breach of the Fuel Supply Agreement;4) breach of the Purchase Agreement; and 5) breach of the Right of First Refusal Agreement. The Alliance Action ultimately settled for Uni-Marts’ agreement to pay the buyers $2 million and $25,000 in settlement administration costs, as well Uni-Marts’ agreement to certain changes in the contracts.


Uni-Marts sought coverage under its D&O insurance policy for its costs of defending the Alliance Action as well as for the cash amounts of the settlement. The D&O insurer denied coverage relying among other things on the policy’s contract exclusion, which provided that no coverage will be available “based upon, 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.” The carrier filed an action in federal court seeking a judicial declaration that coverage was precluded. The parties filed cross-motions for summary judgment.


The August 17 Holding

There was no dispute that count three through five in the Alliance Action were based on Uni-Marts’ alleged liability under a written contract. The parties disputed whether or not coverage was precluded by the policy’s contractual liability exclusion for the negligent misrepresentation and fraud in the inducement counts in the Alliance Action. Uni-Marts argued that the two tort claims arise out of pre-contractual conduct and stand alone from the contract claims.


Judge Nealon held, “giving plain meaning to the unambiguous language of the contract exclusion,” that the fraudulent inducement and negligent misrepresentation claims “certainly are ‘based upon, arising out of, or in consequence of any actual or alleged liability’ under the contracts.” The tort claims, Judge Nealon found, “arise from the same essential facts and circumstances from those which underlie the breach of contract claims.” 


Of particular importance to Judge Nealon in reaching this conclusion is the fact that “the financial information relied upon by the class plaintiffs [in the Alliance Action] was incorporated into the Purchase Agreements.” Judge Nealon interpreted the plaintiffs in the underlying action as having alleged that the specific financial representations on which the plaintiffs relied as having been incorporated into the Representations, Warranties and Covenants section of the Purchase Agreement. Based on this determination, he concluded that “the fraud in the inducement and negligent misrepresentation claims are based upon, arise from, or are in consequence of Uni-Marts’ liability under the agreements.”


Judge Nealon also went on to make a “but for” analysis with respect to the fraudulent inducement and negligent misrepresentation claims, asking “would the store owners’ fraud in the inducement and negligent misrepresentation claims exist even in the absence of the contracts and breach thereof. The answer to that question is no. Had the class plaintiffs not entered into the contracts and had Uni-Mart no breached the contracts, there would be no independent tort claims” because “the injuries suffered by the class plaintiffs would not have occurred had there been no contracts and no breach thereof.”


Judge Nealon concluded by noting that requiring the insurer “to cover this loss, which its essence is derived from a business agreement gone bad, would be greatly expanding the coverage of the D&O policy beyond that which is called for by the plain language.”



For many readers, this case my present something of a surprise outcome. Certainly, claims for fraudulent inducement and negligent misrepresentation arguably represent the very kinds of things for which policyholders purchase D&O insurance. However, the outcome of this case can be understood as a reflection of two factors that interacted in this situation: the exclusion’s broad preamble, and Judge Nealon’s determination that the financial misrepresentations had been incorporated into the agreement.


In a prior post about the contractual liability exclusion generally, I have noted how extensively a contract exclusion with the broad “based upon, arising out of” preamble can sweep. While most private company D&O insurance policies have some form of contract exclusion, not all policies have adopted the broad preamble. The scope of language in the exclusion can substantially affect the extent of coverage available under the policy. In general, courts have applied a broadly preclusive interpretation to exclusions with the broad preamble language.


However, not every decision has swept so broadly as to preclude coverage for the types of tort claims asserted here; in particular, Judge Nealon was forced to try to distinguish a relatively recent Western District of Pennsylvania decision in which the court, under very similar circumstances, found that misrepresentation claims were not precluded from coverage. The way that Judge Nealon distinguished the prior case and reached the conclusion that the exclusion here precluded coverage was through his determination that all of the financial misrepresentations on which the plaintiffs relied had been incorporated into the Purchase Agreement. I suspect that not every reader will be persuaded by this analytic legerdemain. But this determination is in any event a distinct characteristic of this decision that may allow it to be distinguished in any future cases involving both breach of contract and misrepresentation claims.


The troublesome thing about the breadth of the preclusionary effect given here to the contractual liability exclusion is that some type of transaction is at the heart of many claims under a private company D&O insurance policy. The danger is that insureds could find themselves without coverge for claims of a kind that might well have assumed would be covered, but because of the involvement in the claim of an underlying transaction and because of the expansiveness of the D&O insurance policy’s contract exclusion are precluded from coverage.


The real problem here may be the expansiveness of the preamble to the exclusion. Clearly, the use of the broad "based upon" and "arising out of" language was instrumental to the outcome (setting aside of course the concerns about Judge Nealon’s determination that the financial representations had been incorporated into the Purchase Agreement).


Many carriers will insist on using the broad preamble for the contractual liability exclusion and will refuse to use the narrower “for” preamble language. However, given the extent of the preclusive effect that courts have found in interpreting policies with the broad omnibus wording, policy forms using the narrower "for" wording are, in this respect at least, clearly superior from the policyholder’s perspective, particularly if carriers whose policies have the broader wording choose to try to apply the exclusion to preclude a wide swath of claims.


I would argue that the "for" wording is much closer to the original purposes for the inclusion of the contract exclusion in private company D&O insurance policies – that is, an exclusion with the "for" wording makes it clear that insurers do not intend to pick up the insured company’s contractual liability, without extending the potential preclusive effect, for example, to tort claims alleging a different variety of wrongful conduct.


SEC Awards First Whistleblower Bounty: When the whistleblower bounty provisions in the Dodd-Frank Act were enacted, there were concerns that the provisions – allowing whistleblowers an award between 10% and 30% of the money collected when information provided by the whistleblower leads to an SEC enforcement action in which more than $1 million in sanctions is ordered – would encourage a flood of reports from would be whistleblowers who hope to cash in on the potentially rich rewards.


However, if the SEC’s first award under this program is any indication, some whistleblowers may decide to curb their enthusiasm. As reflected in the SEC’s August 21, 2012 press release (here), the agency has now made its first whistleblower award for the relatively modest amount of $50,000. According to the press release, “the award represents 30 percent of the amount collected in an SEC enforcement action against the perpetrators of the scheme, the maximum percentage payout allowed by the whistleblower law.”


The press release also explains that the whistleblower’s assistance led to a court ordering more than $1 million in sanctions, of which approximately $150,000 has been collected thus far. The court is considering whether to issue a final judgment against other defendants in the matter. Any increase in the sanctions ordered and collected will increase payments to the whistleblower.


There undoubtedly will be other awards, some of which undoubtedly will be larger. But for the first example, this modest award itself is unlikely provide much encouragement to prospective whistleblowers.