If You Don’t Reach Conclusion, Forget the Exclusion
When it comes to conduct exclusions, be mindful of your burden of proof
An insurer’s obligation to indemnify its insured in an underlying lawsuit typically depends on how facts and evidence compare to the policy’s coverage provisions. If the evidence takes the claim outside of the policy’s coverage, then the insurer can challenge its obligation to indemnify. In such cases, the insurer can refuse to participate in a settlement during the pendency of the underlying suit against its insured.
This, however, does not hold true when an insurer is challenging coverage based on a conduct exclusion with an adjudication condition. These exclusions are found in most directors and officers (D&O) policies, and are also frequently used in cyber and errors and omissions (E&O) policies. The exclusions generally bar coverage for damages flowing from conduct of the insured that was fraudulent, criminal, or intentional. They can also extend to wrongdoing resulting in improper profit or financial advantage for the policyholder.
The important component of many of those provisions is the carve-back for coverage unless and until the insured is found liable for such conduct through a “judgment” and/or “final adjudication” in the underlying suit. The adjudication condition can be a significant factor in the insurer’s ability to challenge coverage for an insured’s fraudulent conduct.
Although case law on the topic is not ubiquitous, there is some guidance on when the judgment or final adjudication condition may be satisfied. In Unencumbered Assets v. Great Am. Ins. Co., the insureds sought coverage from their excess D&O insurer for certain civil lawsuits filed by investors of the bankrupt insured business. Meanwhile, the government successfully pursued criminal charges against the insureds for deceiving investors and auditors.
While the criminal convictions were on appeal, the insurer argued that the insureds were not entitled to coverage based on a policy exclusion for a claim brought about by a “deliberately fraudulent or deliberately dishonest act or omission…if a judgment or other final adjudication adverse to the insured establishes” such conduct. The insureds argued the exclusion could not apply as their criminal convictions were on appeal and were not “final” when the insurer challenged coverage.
The court rejected the insureds’ argument and found the insurer correctly denied coverage. The criminal convictions contained fraudulent conduct as an element of the offenses committed by the insureds, and the criminal juries found that the violations were knowing and willful. The court found that the potential for further appellate review of the criminal convictions was not enough to survive the exclusion; all that was required by the policy was a “judgment” establishing fraudulent conduct, and there was no language in the policy requiring exhaustion of appellate review in order for the exclusion to apply.
Whether an adverse ruling against an insured satisfies the adjudication condition depends upon the procedural status of the underlying suit compared to the language of the policy. Carve-back language varies from policy to policy, and the threshold question will be what the policy terms require to exclude coverage.
Even if the insurer is equipped with a judgment or final adjudication against its insured, it must also be able to identify a finding of fact within that adjudication that triggers the exclusion. In St. Luke’s Health Sys. v. Allied World Nat’l Assur. Co., the policy excluded coverage where the insured is found liable through a “final judgment or adjudication” for “gaining of any profit or financial advantage” to which it was not legally entitled. Although there was a final adjudication adverse to the insured in the underlying lawsuit, the judgment did not specifically find that the insured gained a financial advantage it was not entitled to, but rather that the insured improperly gained “bargaining leverage” through its conduct.
The insurer attempted to equate “bargaining leverage” with a “financial advantage” to invoke the exclusion but the court rejected that argument, suggesting the insurer should have drafted the exclusion with broader language if it was meant to encompass such conduct.
As the application of conduct exclusions hinges upon a specific factual finding consistent with the language of the exclusion, attention needs to be given to whether an underlying suit against an insured will actually require a ruling on that conduct. In that vein, insurers should be cognizant of their ability to intervene in an underlying lawsuit to pose special interrogatories to the fact-finder to seek a ruling on the insured’s conduct.
Courts in some jurisdictions have been reluctant to allow insurers to re-litigate aspects of an underlying suit in a post-judgment effort to resolve the insurer’s coverage defenses. Ensuring that the judgment in the underlying suit squarely addresses the conduct referenced in a conduct exclusion will provide a much clearer path for an insurer to properly deny coverage for the judgment.
Conduct exclusions can also implicate other considerations that impact an insurer’s participation in the defense of a claim. If the policy imposes a duty to defend, the insured may be entitled to employ independent counsel at the expense of the insurer in light of the potentially divergent interests between the insured and insurer. Armed with the knowledge that a final adjudication in an underlying suit may be fatal to his or her client’s claim for coverage, that independent counsel (and the insured’s own coverage counsel) will likely advise the insured to seek resolution of the claim before an adverse judgment is final and non-appealable. In that scenario, an insurer should evaluate whether the policy requires its consent to settlement and how that might impact the insured’s ability to resolve the claim prior to final judgment.
The rulings in Unencumbered Assets and St. Luke’s provide instruction on when conduct exclusions can form the basis of a coverage denial. The pivotal questions are whether the underlying suit has actually reached the procedural stage that satisfies that policy language and whether the underlying adjudication actually addresses the excluded conduct. As courts strictly construe these exclusions, insurers must be mindful of their burden of proof before denying indemnity coverage to policyholders.