Although analysts' estimates of directors and officers liability insurance losses related to the subprime crisis reach as high as $9 billion, insurers may look to standard D&O policy exclusions to lower ultimate payouts.

Based on a review of court rulings in D&O coverage matters, however, it is not entirely clear that insurers will be successful in relying on one particular exclusion–the dishonesty exclusion.

While the exclusion may cushion some of the losses for insurers, courts reviewing the applicability of exclusion have focused on the specific language of the exclusion, whether a dishonest insured engaged in intentional wrongdoing, and whether there has been a finding that an insured actually engaged in the excluded conduct.

The meltdown in the subprime mortgage market has spread from subprime lenders to the housing market overall, shaken Wall Street and major financial institutions, and threatens the U.S. economy with recession. It has produced a wave of criminal investigations and civil lawsuits against lenders, mortgage brokers, appraisers, investment companies and others. While a wide variety of claims are being asserted, many involve allegations of fraud and criminal misconduct.

In the D&O context, fraud allegations arise in lawsuits brought by shareholders suing their corporate managers for breach of fiduciary duty and for violations of state and federal securities laws for failing to disclose the corporation's financial exposure to subprime losses.

In the professional liability, or E&O context, many suits have been brought against service provider firms, such as mortgage brokers, mortgage lenders, property appraisers and others alleging there was a malfeasance or a misrepresentation about the value of the property or a misrepresentation about how the loan operated, how the adjustable rate functioned, and how much the loan would actually cost.

Earlier this year, New York-based Advisen Ltd.–a provider of technology and data to the commercial insurance industry that has been tracking financial institution write-downs across the globe–estimated that write-downs of subprime exposures by 120 financial institutions exceeded $230 billion, and that D&O losses for these institutions could reach $3.6 billion.

The Advisen report came on the heels of another analysis from Bear Stearns, estimating a “potential worst-case scenario” of $9.3 billion in D&O and E&O insurance losses arising from the subprime mortgage crisis. (See NU, Feb. 16, page 29 for details.) Although the Bear Stearns analyst suggested that self-insurance for some large financial institutions could lower the insurance industry's ultimate payout to a range of $8-to-$9 billion, the report did not analyze the possible application of policy exclusions.

When faced with a claim for insurance coverage under a D&O or E&O policy, there are a multitude of potential coverage issues that can arise which must be addressed by a claim analyst or claim professional. One such issue, which may have particular relevance to the subprime meltdown, is whether coverage may be barred by the dishonesty exclusion.

The potential application of this exclusion is widespread because virtually all of the claims in this area allege some type of fraudulent or dishonest misconduct. Although the wording of this exclusion varies from one policy to another, it typically will bar coverage for claims arising out of dishonest, fraudulent, or criminal acts, errors or omissions committed by the insured. (See accompanying story, “What Do Policies Say,” for examples of the exclusionary language.)

Courts construing the meaning of “dishonesty” in such exclusions usually have required that the acts under scrutiny involve some sort of willful or intentional misconduct accompanied by a dishonest purpose.

For example, the Fourth Circuit U.S. Court of Appeals in Atlantic Permanent Federal Savings & Loan Association v. American Casualty Co., held in a 1988 ruling that conduct does not constitute, or rise to the level of, dishonesty, for purposes of the exclusion, if the insured did not act “with actual dishonest purpose and intent.”

More recently, in 2000, the U.S. Court of Appeals for the Seventh Circuit held in Citizens First Nat'l Bank of Princeton v. Cincinnati Ins. Co. that the dishonesty exclusion did not bar coverage because the insured acted with “pure heart but empty head” in making risky investments leading to large financial losses.

In another case decided in 1995, the United States District Court for the Southern District of New York held, in In re Donald Sheldon & Co., that a jury's finding that the insured had breached a fiduciary duty and had acted in bad faith did not establish “dishonesty” under the exclusion, reasoning that the jury could have found bad faith and breach of fiduciary duty without a finding of dishonest purpose and intent.

These decisions have given a fairly narrow construction and limited application to the exclusion.

By contrast, the Fifth Circuit Court of Appeals ruled in 1990 in Federal Deposit Ins. Corp. v. Mmahat that a jury's finding that the insured had breached a fiduciary duty constituted a final adjudication of dishonesty because the conduct giving rise to the breach involved intentional wrongdoing for the purpose of generating fees to which it had not been entitled.

In International Surplus Lines Ins. Co. v. University of Wyoming Research Corp., where language in the exclusion barred coverage for claims arising out of dishonest acts, the court ruled in 1994 that fraud “epitomizes the essence of dishonesty” and held that there was no coverage for a civil fraud claim.

One issue that often arises in determining whether the dishonesty exclusion will bar coverage is whether or not the exclusion can be invoked by the insurer without a final adjudication that the insured had actually engaged in the excluded conduct.

As the two exclusions quoted in the accompanying examples show, many forms of the exclusion on their face seem to require that the requisite conduct be established by a judgment or final adjudication in the underlying action. Because many cases against directors and officers settle before there is any actual verdict, the issue arises as to whether the insurer can actually rely on the exclusion in those instances.

Can the insurer seek to get a final or an actual adjudication by filing a collateral declaratory judgment proceeding against the insured? Can a court declare the exclusion applicable as a matter of law, without any actual factual adjudication or any actual determination by a jury or fact finder?

Many courts have held that if the claims are settled before a final judgment or adjudication, the dishonesty exclusion does not apply because the exclusion, on its face, requires an actual adjudication that places the conduct at issue within the scope of the exclusion. PepsiCo Inc. v. Continental Casualty Co. (S.D.N.Y. 1986); Atlantic Permanent Federal Savings & Loan Association v. American Casualty Co., (4th Cir. 1988); National Union Fire Insurance Co. v. Continental Illinois Corp., (N.D. Ill. 1987); AXIS Reinsurance Co. v. Bennett, (S.D.N.Y., June 26, 2008).

Moreover, some courts have even held that the adjudication must take place in the underlying action itself, not in a collateral coverage action between the insured and the insurer. First National Bank Holding Co. v. Fidelity Deposit Co., (N.D. Fla. 1995); National Union Fire Insurance Co. v. Seafirst Corp., (W.D. Wash. 1986); Finci v. American Casualty Co., (Md. 1991).

Furthermore, some courts have held that in order for a jury's findings in an underlying action to be considered a final adjudication of the excluded conduct, the findings must be conclusive, so that if a jury could have reached its verdict without a finding of dishonesty or other excluded conduct, the exclusion will not apply. In re Donald Sheldon & Co., (S.D.N.Y. 1995); Continental Casualty Co. v. Tierney, (W.D. Mo. July 2, 1991).

When an insured pleads guilty to a criminal fraud charge, however, such a plea has been held to constitute a final adjudication of dishonest acts and will bar coverage. (First National Bank Holding Co. v. Fidelity Deposit Co., N.D. Fla. 1995).

Because the “final adjudication” language can effectively take the exclusion out of play, some insurers modified the exclusion so that it simply requires that the excluded conduct “in fact” took place. Where the exclusion contains that language, it may bar coverage for sums paid in settlement if it is determined that the excluded conduct actually occurred. Such language was applicable, for example, in Stargatt v. Avenell, (D. Del. 1977).

In addition, absent the “final adjudication language,” one court–the Fifth Circuit Court of Appeals in American Casualty Co. v. United Southern Bank–has held that the insurer may litigate the applicability of the exclusion in a collateral coverage case.

But not all courts have gone this way. For example, in a recent decision in AT&T v. Clarendon America Ins. Co. (Super. Ct. Del., June 25, 2008), the wording at issue was somewhat unique and excluded coverage where the loss was “…brought about or contributed to in fact by any deliberate dishonest, fraudulent or criminal act or omission…and providing any such finding is material to the cause of action so adjudicated.” Despite the fact that the exclusion did not have any “final adjudication” language and instead substituted the “in fact” language, the court nonetheless held that the exclusion required a final adjudication and also held that the final adjudication must take place in the underlying litigation. The use of the “in fact” wording was not found to invalidate the adjudication requirement.

Recently, in Westport Ins. Co. v. Hanft & Knight (M.D. Pa., Dec. 10, 2007), a federal judge in the Middle District of Pennsylvania relied on various policy exclusions and held that an insurer owed no coverage obligation to the estate of a lawyer and the firm he had worked for. There, the underlying suit alleged that the lawyer had borrowed money from the plaintiffs on several occasions, purportedly to purchase property and to fund a construction project.

Eventually, after the lawyer failed to pay back the loans, the plaintiffs discovered that there was, in fact, no construction project and that the lawyer had used the money to gamble and to pay gambling debts. The lawyer committed suicide before the plaintiffs filed the underlying suit to recover the loans.

The underlying suit, which was filed against the lawyer's estate, alleged that the lawyer had made fraudulent misrepresentations and had abused his position as the plaintiffs' attorney.

The plaintiffs also sued the law firm, alleging that it had breached its duty of professional care, breached a fiduciary duty, and violated the Pennsylvania Unfair Trade Practices and Consumer Protection Law.

The court ruled that coverage was precluded by the dishonesty exclusion. The particular exclusion at issue applied to any claim “based upon, arising out of, attributable to, or directly or indirectly resulting from any criminal, dishonest, malicious, or fraudulent act, error, omission…committed by an Insured.” The exclusion, however, did not apply to “any Insured who is not so adjudged.”

Seizing on the “not so adjudged” language, the plaintiffs, who wanted a finding of coverage to fund a potential recovery, argued that a jury trial was required before a determination could be made as to whether or not the exclusion applied, arguing that a jury might conclude that the lawyer had simply been negligent.

However, relying solely on the declarations in the complaint, the court found that no reasonable jury could possibly conclude that the lawyer had not been dishonest.

The court also found, in spite of the “not so adjudged” language, that if the insurer were required to defend the action to a final adjudication, the exclusion would effectively be written out of the policy, at least in terms of the defense obligation.

This decision is interesting because it represents a departure from the reasoning of most cases, which have found that the “final adjudication” wording, “not so adjudged” language, or language of similar import, requires an actual verdict in the underlying case which establishes that the excluded conduct actually took place.

Overall, despite some wins for insurers, the dishonesty exclusion is apt to have a bark far worse than its bite. That is because more and more policy wordings have been evolving to employ an exclusion similar to the following: “The Insurer shall not pay the portion of Loss in connection with any Claim that is brought for deliberately fraudulent or deliberately criminal act or deliberately fraudulent or deliberately criminal omission or any deliberate violation of any statute, rule, or law by an Insured, provided always that the applicability of this exclusion shall only be determined by a final adjudication, after exhaustion of all appeals (including petitions for rehearing), in the underlying Claim.”

With the surge in civil cases and criminal proceedings involving allegations of fraud and other dishonest conduct in connection with the subprime mortgage crisis, anyone analyzing whether coverage may be available under a D&O or E&O must always take into account the dishonesty exclusion and the particular language it employs.

Depending on how the language of that exclusion is worded, coverage may or may not be available and, in some instances, insurers may seek to protect themselves by invoking the exclusion even when there has not been a final adjudication of the underlying case.

See related articles:

o What Do Policies Say? Dishonesty Exclusion Examples

o Fixing Blame: Suits, Investigations Mount

o Crisis Origins: How We Got Here

Special Reports /

Will Dishonesty Exclusion Cushion Subprime Losses For D&O Insurers?

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