D&O Coverage Exclusions for Dishonesty and The Great Recession of 2008: The “In Fact” Requirement

October 18, 2013

Insurance LawMy last post examined the “final adjudication” trigger typically found in D&O policy dishonesty exclusions. This post continues that discussion with an examination of the “in fact” trigger typically found in personal profit exclusions.

The “in fact” trigger’s lack of specificity has given rise to confusion about the quantum of proof necessary to establish the exclusion’s applicability. To date, three distinct approaches have emerged.

Pleadings-Based Approach

The approach most favorable to insurers allows the insurer to deny coverage at the pleading stage based the allegations in the underlying complaint. The Seventh Circuit’s decision in Brown & LaCounte, LLP v Westport Ins Corp, 307 F3d 660, 663-64 (7th Cir 2002), illustrates this approach. In holding that the proper way to determine the personal profit exclusion’s applicability under Wisconsin law is to look at the complaint against the insured, the circuit court was particularly solicitous of the insurer’s interests. The court was concerned that if the insurer were required to offer evidentiary proof beyond the complaint that the profited required some proof beyond the complaint, the “an insurer could never invoke the exclusion to deny coverage without first litigating the underlying allegations.” This would render the exclusion “meaningless in contravention of both the plain language of the policy and the parties’ apparent contractual intent to exclude some kinds of claims from coverage.”

“In Fact” = Final Adjudication

The approach most favorable to policyholders equates proof “in fact” with a final adjudication of the facts necessary to determine the exclusion’s applicability. Applying Texas law, the Fifth Circuit adopted the final adjudication approach in Pendergest-Holt v Certain Underwriters at Lloyd’s of London, 600 F.3d 562 (5th Cir 2010).

In Pendergest-Holt, the Fifth Circuit devoted a significant portion of its opinion to the question of whether the judicial determination may be made in a separate coverage action. In finding that the insurer is entitled to litigate the insured’s conduct in a separate coverage action, the court contrasted the express “final adjudication” language found in the policy’s dishonesty exclusion, which the court construed to require an adjudication in the underlying action, to the broader “in fact” language. The absence of an express final adjudication requirement, in the court’s view, meant that the exclusion’s applicability did not depend on a final resolution of the underlying action and instead allowed the insurer to litigate the insured’s conduct in a separate coverage proceeding.

A Hybrid Approach

A third approach adopts a middle ground between the other two approaches by requiring more than mere allegations in the underlying complaint but less than a full judicial adjudication. Applying Arkansas law, the Eighth Circuit attempted to articulate this middle approach in  Wintermute v Kansas Bankers Surety Co., 630 F3d 1063, 1074 (8th Cir 2011). The court explained that an “in fact” personal profit exclusion requires only “some” proof of the exclusion’s applicability and allowed the insurer to make that showing in a separate coverage action. That fact that the insured had been acquitted of criminal charges when the case reached the Eighth Circuit did not, in the court’s view, defeat the exclusion. The court therefore remanded for further proceedings without clarifying what “additional proof” was required to establish the exclusion’s applicability.

Implications of Each Approach

All three approaches have flaws. The obvious flaw in the Wintermute approach is that it engenders uncertainty about the when the exclusion applies. While Brown & LaCounte has the virtue of simplicity, its reliance on the pleadings in the underlying case makes coverage unduly dependent on the underlying forum’s pleading rules: A complaint filed in a notice pleading state is less likely to contain sufficient information to justify invoking the exclusion than a complaint filed in a code pleading state.

None of the three approaches accounts for whether the policy imposes a duty to defend on the insurer. If the insurer does have a duty to defend, the duty exists whenever factual disputes give rise to a potential for coverage. Allowing the insurer to resolve those factual disputes in a separate proceeding while the underlying action is pending would be inconsistent with the insurer’s obligation to defend as long as potentially covered claims exist in the underlying action.