A couple of items crossed my desk last week that made me think about two exclusions that are sometimes found in D&O insurance policies. In each case, the exclusions, while relatively uncommon, could substantially restrict the insurance coverage available at least in certain circumstances. Precisely because these exclusions are relatively uncommon, it is important to understand the circumstances to which they apply and how they can affect coverage when they are triggered.
The Creditors Exclusion
The first of these two exclusions came up in a September 27, 2016 decision by the Fifth Circuit (here). The case involved the question of a D&O insurer’s duty to defend and indemnify insured persons who had been sued in a misrepresentation action. Color Star, a company involved in the wholesale flower trade, had entered a $52.5 million credit facility. Color Star eventually defaulted on its obligations under the credit facility and filed for bankruptcy. The lenders that had participated in the credit facility sued the Verbeeks, who were the owners and officers of Color Star. The lenders alleged that they procured the credit facility for Color Star by misrepresenting the company’s financial condition.
The Verbeeks tendered the claim to Color Star’s D&O insurer. The D&O insurer denied that it had any duty to defend or indemnify the Verbeeks. In denying coverage, the D&O insurer relied on the policy’s Creditor Exclusion.
The D&O insurer initiated an action seeking a judicial declaration that there was no coverage under the policy. The Verbeeks filed a counterclaim for breach of contract. The parties in the coverage action filed cross-motions for summary judgment. The district court granted the D&O insurer’s motion for summary judgment and the Verbeeks appealed.
The Creditor Exclusion provides that
The Insurer shall not be liable to pay any Loss on account of, and shall not be obligated to defend, and Claim brought or maintained by or on behalf of: Any creditor of a Company or Organization in the creditor’s capacity as such, whether or not a bankruptcy or insolvency proceeding involving the Company or Organization has been commenced.
On appeal, the Verbeeks argued that the exclusion’s “capacity requirement” meant that the exclusion is triggered only by claims brought by creditors to recover for the debt owed. The lenders in the credit facility, the Verbeeks argued, were not seeking recovery under the credit facility, but were claiming that they had been misled, and therefore the exclusion was not triggered.
In a September 27, 2016 unpublished per curiam opinion, a three-judge panel of the Fifth Circuit rejected the Verbeeks’ argument and affirmed the district court’s ruling. The appellate court held that the Creditors Exclusion precluded coverage for the Verbeeks’ claims.
In ruling in favor of the D&O insurer, the appellate court noted that the factual allegations in the underling state court litigation indicated that all of the damages originated from the loans that the Verbeeks had allegedly induced the lenders to extend to Color Star. Because the “origin of the damages” stems from the lenders’ roles as defrauded creditors of Color Star, the Creditor Exclusion bars coverage.
The appellate court also rejected the Verbeeks argument that the exclusion did not apply because one of the plaintiffs in the underlying case, the corporate parent of the actual lender that extended the credit, was an investor and administrative agent and not a creditor. The court said that the corporate parent’s reference in its pleading to its investment in the loan did not bring the underlying litigation outside the scope of the exclusion “because the factual allegations reveal that the origin of the damages is the fraudulently induced loans.”
Finally, the court also rejected the Verbeeks’ argument that the bankruptcy court’s approval of liquidation plan for Color Star meant that the plaintiffs in the underlying lawsuit were no longer “creditors.” The appellate court noted that the complaint was filed prior to the confirmation, and the exclusion was written in the disjunctive, barring coverage for any claim “brought or maintained” by a creditor.
The appellate court’s holding arguably is no surprise, since the exclusion does not apply to types of claims but to claims brought by types of litigants. If the claim is brought by a creditor acting as a creditor, the claim is precluded from coverage. The claimants in the underlying lawsuit claimed they were induced to become creditors because of financial misrepresentations. It was always going to be a hard argument that in asserting those claims the creditors were proceeding in some capacity other than as creditors.
It is a arguably harsh to extend this logic to the claimant that was the corporate parent of the actual lender; at least of the parent company was proceeding in its own right and not in the right of the actual lender, it is hard to see how this claimant’s claim can be said to be “brought or maintained by or on behalf of any creditor of a Company or Organization.” The exclusion precludes coverage only for claims by certain claimants; the corporate parent is not that type of claimant.
In commenting on this decision in an October 11, 2016 memo (here), the Dechert law firm noted that, in light of the Fifth Circuit’s ruling, “D&Os should be vigilant in reviewing their company’s D&O policies to ensure that they provide meaningful coverage without buried exclusions that may negate coverage at times it is most required.” This is certainly a true statement about exclusions in general, and given the outcome of this coverage dispute, it is unquestionably true that any policyholder would want to know if their policy has a creditor exclusion.
It is also important to know when a policy might have this type of exclusion. The fact is that it is relatively unusual for policies to have creditor exclusions (or the broader bankruptcy exclusions). In most normal business circumstances, if an insurer were to offer coverage terms that included a proposed creditor exclusion, the prospective policyholder could avoid this restriction simply by going to another insurer that would offer terms without the exclusion. However, going to another insurer is not an available option if there is not a competitor willing to offer terms without the exclusion.
The fact is that the occasions in which an insurer might offer terms only with a creditor exclusion is when the prospective policyholder is financially distressed. A company’s financial condition and its ability to pay its debts are among the most important things that an underwriter considers when underwriting a risk. If it looks like a company is struggling financially and may have trouble paying its debts, an insurer may well only be willing to offer terms at all if the terms include a creditor exclusion.
And unlike financially healthy company, a financially struggling company may not be able to get alternative terms from other carriers. At that point, the company’s only alternative may be to accept coverage with a creditor exclusion or to forego coverage altogether. The company may conclude that even if the coverage available is severely restricted given the financial circumstances facing the company, they are still better off buying the coverage than doing without it.
In other words, while it unquestionably is a good idea for directors and officers to review their policies to ensure that the policies do not have restrictive exclusions, there may be times when a policyholder has a policy with a restrictive exclusion when there may be little that the policyholder can do about it. That said of course it may be possible to have the exclusion removed if there are alternative markets available or if the company’s financial conditions have improved, and it is certainly important for the company to do so if it is possible.
The Failure to Maintain Insurance Exclusion
The second of the two cases to cross my desk last week and to make me think about D&O policy exclusions didn’t actually involve a coverage dispute ; rather, the case involved an attempt to impose liability on a corporate director in the relatively unusual kind of circumstance that, were insurance coverage at issue, might trigger a failure to maintain insurance exclusion.
The case arose in the U.K. and involved a claim by a Mr. Cambell, who was an employee of a company of which Mr. Gordon was the sole director. Cambell was injured on the job while working with a circular saw. The company had employers’ liability insurance, but the insurance policy excluded liability for claims involved electrical woodworking machinery. The company went into liquidation in 2009. Campbell sought to have Gordon held personally liable for the company’s failure to provide adequate insurance cover on the basis of Sections 1(1) and 5 of the Employers’ Liability (Compulsory Insurance Act) of 1969.
In a July 6, 2016 Judgment (here), a split five-judge panel of the U.K. Supreme Court ruled by a 3-2 vote that ELCIA did not impose on a director a duty to insure, nor did it impose any civil liability for failing to do so. The duty to insure, the court found, was on the company. The piercing of the corporate veil and the imposition of liability on a director is only permissible in limited circumstances when the director is “deemed to be guilty of the offense” and then solely for criminal liability. The court refused to infer civil liability.
This decision is of greatest interest for the immediate question that the Court addressed, that is, whether directors can be held liable in a civil action for the failure to obtain or maintain insurance under the applicable statutory provision. Several recent law firm memos discuss this aspect of the court’s decision, including, for example DAC Beachcroft’s October 4, 2016 memo about the case (here), and Cooley’s July 19, 2016 memo (here).
However, the case is of interest to me for a slightly different issue. That is, the case presents an example of the kind of claim that might trigger a D&O insurance policy’s failure to maintain insurance exclusion. These kinds of exclusion used to be fairly common in D&O insurance policies. They are now relatively rare but you do still do see policies from time to time that have these exclusion. Because these exclusions are unusual, not everyone is going to be familiar with them and so not everyone will appreciate how the exclusion might affect coverage or even the kind of circumstances in which the exclusion might become relevant.
The wordings for these kinds of exclusions vary but the typical exclusion would provide something like this: The Insurer shall not be liable to pay any Loss based upon, arising out of, or in any way relating to the failure to acquire, purchase or maintain insurance, including but not limited to the failure to acquire, purchase, or maintain sufficient, adequate, or suitable insurance.
The reason the insurers included the exclusion was so the D&O policy did not wind up operating as a sort of back up insurance policy for other coverages the policyholder meant to or should have purchased. This exclusion became relatively uncommon some time ago, but it went through a brief return shortly after 9/11, when the insurers became concerned that the D&O policy might want up as a sort of backstop for the failure to purchase insurance protecting against losses arising from a terrorism event.
You don’t see this exclusion very often these days; pretty reliably, the only time I see this exclusion now is on a policy that has just been renewed year after year without much thought, and the exclusion just got carried along with each renewal – which is of course yet another reminder to have D&O policies reviewed to make sure there aren’t obscure exclusions tucked into the policy that could result in a bad surprise in the event of a claim.
Some time ago, back when this type of exclusion was relatively more common, it became pretty much standard industry practice that the insurer would remove the exclusion upon request and upon provision of a schedule of insurance. That is still pretty much the case. The key, however, is that you have to ask to have it removed. If no one asks, the exclusion will remain on the policy and get carried forward year after year through successive renewals.
Because these exclusions are unusual, it may be that some may be unaware of what the exclusion is there for, and what it might represent. What the exclusion is there for is a situation like this one, where the intended employers’ liability coverage did not provide coverage, and so a claimant tried to impose the costs related on an uninsured injury on one if his employer company’s directors. In this case, the court held that there was no civil liability, but the claim still had to be defended. Moreover, in different circumstances, the director might have needed to be indemnified as well, for the costs of any settlement or judgment.
The director facing this type of claim would certainly want his or her company’s D&O insurance policy to fund his or her defense, and if necessary, indemnify him or her for any settlement or judgement. If, however, the company’s D&O insurance policy had a failure to maintain insurance exclusion, the insurer might well have sought to deny coverage – and not only for the settlement or judgment amount, but also even for the costs of defense.
Of course, the case U.K. case discussed above was not an insurance coverage case; rather it was focused on the underlying liability. Even though the case did not present any insurance coverage issues, I am conjecturing here on the possible insurance angle in order to show how the presence of a failure to maintain insurance exclusion might operate to preclude coverage in certain circumstances. Because both the exclusion and the relevant circumstances are rare, I wanted to be sure to highlight this case, so that the next time readers run across one of the relatively rare policies that has a failure to maintain insurance exclusion, they will understand what it is there for.
In closing, I want to make a final point about these exclusions and other kinds of exclusions that can sometimes turn up in a D&O insurance policy. That is, these kinds of exclusions can significantly affect the coverage available in certain circumstances. It may be possible to have these exclusions removed, although that is certainly not going to happen if their removal is not requested. A request to have them removed is less likely if the exclusions’ possible effect on coverage or the circumstances in which the exclusions might come into play are not fully understood. All of which underscores the critical importance of having a knowledgeable and experience insurance advised involved in the insurance placement process.
PLUS Chapter Event: On October 20, 2016, I will be participating in a PLUS Southern California Chapter educational event in Los Angeles. The event will take place at the Jonathan Center. The educational session will address the upcoming Presidential election’s potential effect on employment practices liability insurance and on cyber liability. The educational event will run from 2 pm to 4 pm and will be followed by a reception. More information about event including how to register can be found here.