D&O Coverage Exclusions for Dishonesty and The Great Recession of 2008: The Final Adjudication Requirement

October 17, 2013

Insurance LawAt the heart of the subprime mortgage crisis and the Great Recession of 2008 was the misalignment of financial incentives for individual decision-makers with the long-term interests of the business enterprise and the economy as a whole. The Dishonesty and Personal Profit exclusions in D&O and E&O policies are designed to preclude coverage for liability arising out of improper attempts to take advantage of these mismatched incentives.

Although the language of both exclusions varies from insurer to insurer, the typical Dishonesty Exclusion applies broadly to damages arising out of the “dishonest” or “deliberately dishonest” acts of an insured . The typical personal profit exclusion applies to a narrower range of wrongful conduct, precluding coverage for claims “arising out of . . . any personal profit or advantage to which the Insured is not legally entitled.”

Both exclusions contain language indicating how they are triggered, although the specific trigger can change from policy to policy. The trigger language typically found in Dishonesty Exclusions is most favorable to policyholders, requiring a judgment or final adjudication of the insured’s dishonesty. The trigger typically found in personal profit exclusions is less specific, requiring proof that the insured “in fact” gained a profit or advantage to which he or she was not entitled. The “in fact” standard’s lack of specificity allows for a wider range of judicial interpretation, resulting in a lower evidentiary burden for insurers. This post examines the final adjudication requirement. My next post will examine the “in fact” requirement.

Final Adjudication Requirement

Most battles over the applicability of the final adjudication requirement concern the degree of control insureds will be afforded over determining the exclusion’s applicability. A threshold question is whether the exclusion’s applicability must be determined in the underlying action against the insured or whether the insurer will have the opportunity to litigate the question in a separate coverage action. Some courts have held that the insured’s dishonesty must be litigated in the underlying action, and thus the dishonesty exclusion is inapplicable if the insured settles without an adjudication or admission of wrongdoing. Although acknowledging that this result deprives the insurer of the opportunity to prove the insured’s dishonest purpose, courts point out that the insurer drafted the policy language requiring a final adjudication and must live with the consequences.

Implications of Admitting Fault

An issue that has not been addressed is whether an admission of fault in a settlement agreement is a sufficient final adjudication of liability. This issue is likely to arise with greater frequency in light of indications that the Securities and Exchange Commission is changing its historical practice of settling cases without requiring an admission of liability. In June 2013, SEC Chairwoman Mary Jo White announced that in “egregious” cases of fraud the Commission would insist on admissions of guilt from the targets of its investigations, rather than allowing them to sign settlements that contain “neither-admit-nor-deny” clauses.

Whether a settlement containing an admission of liability constitutes a “final adjudication” should depend on the circumstances surrounding the settlement. The first case to implement the SEC’s new policy—the August 19, 2013 settlement with New York-based hedge fund adviser Phillip Falcone and his advisory firm Harbinger Capital Partners—includes a detailed factual admission in the public court record, which is  incorporated verbatim into the Final Consent Judgment filed with the court. Nowhere, however, do the Harbinger defendants expressly admit to “fraud.” Moreover, the Consent Judgment states that nothing in the agreement affects the defendants “right to take legal or factual positions in litigation or other proceedings or other legal proceedings in which the Commission is not a party.” How such a reservation affects the defendant’s right to contest the culpability of their conduct in collateral proceedings, particularly insurance coverage proceedings, remains to be seen.