In This Issue:

  • No Policy? No Problem, The First Circuit Rules In A Coverage Dispute
  • Ninth Circuit: Professional Services Exclusion Precludes Coverage For Ponzi Scheme
  • Pennsylvania Narrows Employer Liability Exclusion
  • Guilty Pleas By Executives Allow D&O Insurer To Recoup Costs

No Policy? No Problem, The First Circuit Rules In A Coverage Dispute

Why it matters: This case addresses the standard for pleading a missing insurance policy where the alleged insured, a private educational institution, cannot directly allege that the policy existed. In 2013, the school received a demand letter concerning conduct during the 1967-1968 school year (the nature of the conduct was not stated). The school had evidence that the insurer, New Hampshire Insurance Company, had sold coverage to the school at some point, but had not found evidence of coverage at the relevant time. The school provided notice of the claim to New Hampshire, which refused to defend on the ground that there was no evidence of coverage. The school then filed a declaratory judgment action against the insurer.

The district court granted the insurer’s motion to dismiss, but the U.S. Court of Appeals for the First Circuit reversed. The school’s complaint cited indirect, circumstantial evidence that New Hampshire had issued a policy during the relevant time period with $1 million limits. The appellate court ruled that the school’s reliance on sworn statements of former employees and contemporaneous financial audits that tended to support the school’s position established “a plausible basis, beyond a mere possibility,” that the insurer issued the policy in question. This case then provides a good example for how to bring a coverage action where proof of the policy’s existence is uncertain.

Detailed discussion: In 2013, Cardigan Mountain School, a private middle school, received a demand letter making a claim arising from events that allegedly occurred during the 1967-1968 academic year. The school gave notice and sought a defense from New Hampshire Insurance Company.

Cardigan could not locate the applicable policy, but engaged in background research about coverage. It found an outside audit report for Cardigan dated September 1971 stating that the school had a “Special Multi-Peril” insurance policy from New Hampshire. The report was accompanied by an affidavit from one of the two individuals who prepared the report, stating that the auditors would have noted in the report if the school had changed carriers between the 1969-1970 school year and the 1970-1971 school year. This information was included with Cardigan’s complaint.

Cardigan also included with the complaint the affidavit of Cardigan’s business manager between 1967 and 1970, who expressed his certainty that the school had insurance during his tenure and that he did not believe the school changed carriers during his years as business manager. He also recalled working with a local insurance brokerage to secure coverage, which brokerage “had a close association with” New Hampshire and advised “most of its commercial clients like Cardigan” to place their commercial lines of insurance with New Hampshire.

The insurer rejected the request, explaining that it had not been able to locate any policy covering the school for that time period and therefore had no duty to defend.

Cardigan—which had not found a copy of the policy in its own records—filed a declaratory action seeking a judgment decreeing the existence of, and its rights under, a policy issued by New Hampshire. A federal district court granted the insurer’s motion to dismiss the suit and the school appealed.

The First Circuit Court of Appeals focused its opinion on the existence of the policy and not whether the policy—if it existed—covers the claim. The panel first reviewed the evidence set forth in the school’s complaint.

An accounting firm prepared an audit report for Cardigan dated September 1971, which stated that the school had a “Special Multi-Peril” insurance policy from NHIC. The report was accompanied by an affidavit by one of the two individuals who prepared it, stating that he believed if the school had changed carriers between the 1969-1970 school year and the 1970-1971 school year, the auditors would have noted the change in the report.

The school also provided the affidavit of Cardigan’s business manager between 1967 and 1970, who expressed his certainty that the school had insurance during his tenure and that he did not believe the school changed carriers during his years as business manager. He also recalled working with a local insurance brokerage to secure coverage, which brokerage “had a close association with” NHIC.

The insurer argued that the audit report was inconclusive and the other “evidence” was speculative and should be disregarded under Ashcroft v. Iqbal, 556 U.S. 662 (2009), and Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007).

The First Circuit disagreed.

“The allegations in the school’s complaint … are specific and factual,” the court wrote. “The complaint refers to individuals with relevant knowledge who are recalling facts plausibly known to them. Those allegations are thus like the allegations of actual events in Iqbal and of parallel conduct in Twombly that the Supreme Court took as true; they are specific and appear to be based on the knowledge of particular individuals. They are not bare recitations of the legal conclusion the suit seeks to prove. We thus conclude that the school’s allegations set forth above are entitled to the presumption of truth at the motion to dismiss stage.”

The court then found that the circumstantial evidence presented by Cardigan was sufficient to support the reasonable inference that the insurance policy at issue was in place—although it noted the question was close.

Cardigan did “make a plausible showing that New Hampshire Insurance Company issued an insurance policy to the school for the 1967-1968 school year,” the panel concluded. “The school’s allegation of the existence of a New Hampshire Insurance Company policy for the 1970-1971 school year is directly supported by the school’s audit report from that year. And the school’s factual allegations tending to show no change in coverage in the preceding three years are enough to plausibly support the existence of coverage in the 1967-1968 school year.”

The court acknowledged that the factual allegations were circumstantial but said no requirement existed for direct evidence.

“The school has alleged specific facts concerning an audit report that tend to show that it had an insurance policy from New Hampshire Insurance Company as of 1971,” the panel wrote. “And the school has then linked that allegation to the recollections of specific individuals who were involved in the relevant events and are of the view both that the school had a general liability policy in the preceding years, including the crucial 1967-1968 school year, and that there had been no change in carrier during that period of time.”

The court was not persuaded by New Hampshire’s contention that the language of the individuals was vague and indefinite (affidavits stating “I do not believe” that the carriers changed, for example), noting that it was required to draw all reasonable inferences in favor of the school at this stage of the proceedings.

So the business manager’s “lack of a belief that there was a change in coverage (even phrased as it was) is itself a relevant, factual assertion tending to suggest that no such change in coverage occurred,” the court said.

“This case is not one in which a plaintiff has selected an insurance company at random and filed a declaratory judgment action against it in the hopes that the plaintiff might get lucky and find a policy,” the court said. “The school’s complaint instead provides a plausible basis, beyond a mere possibility, for believing that New Hampshire Insurance Company issued the policy in question.”

To read the opinion in Cardigan Mountain School v. New Hampshire Insurance Co., click here.

Ninth Circuit: Professional Services Exclusion Precludes Coverage For Ponzi Scheme

Why it matters: Applying California law, the U.S. Court of Appeals for the Ninth Circuit determined that a professional services exclusion in a D&O policy precluded coverage for a lawsuit against a policyholder based on a Ponzi scheme. The case involved a group of investors who sued a parent company and its subsidiaries asserting that the defendants operated a Ponzi scheme and sold them unregistered securities. The parties to the underlying suit settled by assigning the insureds’ claims against insurance to the plaintiffs.

Pursuant to the assignment, the plaintiffs sued the insurer, which moved to dismiss. The federal district court granted the insurer’s motion to dismiss, and the Ninth Circuit affirmed. The courts agreed with the insurer that the claims were excluded under a professional services exclusion that prohibited claims “for any act, error or omission in connection with the performance of any professional services by or on behalf of the Company for the benefit of any other entity or person.” The investors attempted to circumvent the exclusion by arguing that the provision barred coverage only for acts “directly” connected to professional services and that the acts at issue were “indirectly” performed by the subsidiaries, leaving the provision inapplicable. The courts rejected this argument as unsupported by the contractual language.

Detailed discussion: William Jamison and several other investors filed multiple lawsuits against ePlanning and its subsidiaries ePlanning Securities, Inc. and ePlanning Advisors, Inc. The plaintiffs allegedly purchased millions of dollars’ worth of debt securities from Asset Real Estate & Investment Co. (AREI) on the defendants’ recommendation.

According to the investors, ePlanning misrepresented the assets as carefully vetted, safe investments that met each plaintiff’s investment objectives and risk tolerances. Plaintiffs claimed that the securities in fact were highly speculative, illiquid assets offered in connection with a massive Ponzi scheme operated by ePlanning and AREI.

ePlanning’s E&O policy was exhausted due to other claims, including plaintiffs’ claims in FINRA arbitrations. ePlanning then took the position that the investors’ claims were covered by ePlanning’s separate Directors, Officers and Company Liability Policy (D&O policy) with various underwriters at Lloyd’s.

ePlanning settled with the investors by assigning the company’s potential claims against Lloyd’s. The investors then filed suit against Lloyd’s for failure to defend and indemnify.

A federal district court judge granted the insurer’s motion to dismiss, declining to adopt the investors’ “novel” construction of the D&O policy. The plaintiffs argued that the exclusion was “partial” because it barred coverage for primary liability for the performance of professional services but not for secondary liability incurred by virtue of the subsidiaries’ actions.

The investors pointed to language in the exclusion for applicability to claims “for any act, error, or omission in connection with the performance of any professional services by or on behalf of the Company,” while other policy exclusions featured broader terminology to claims “based upon, arising out of, directly or indirectly from[,] or in consequences of, or in any way involving” the excluded conduct.

Finding the plaintiffs’ interpretation of the exclusionary language “strained to the breaking point,” the district court dismissed their claims.

In an unpublished opinion, the Ninth Circuit agreed, emphasizing the language of the policy.

“The Exclusion is not reasonably susceptible to Jamison’s interpretation,” the panel wrote. “To the extent Jamison’s interpretation would distinguish between ‘direct’ and ‘indirect’ connections to professional services, the Exclusion does not so qualify the phrase ‘in connection with.’”

The court also shot down the investors’ contention that the exclusion did not apply to acts relating to secondary, as opposed to primary, liability.

“Further, Jamison alleges that ePlanning’s subsidiaries rendered ‘direct’ professional services to third party customers without alleging that ePlanning, Inc. also rendered such ‘direct’ services to third party customers,” the panel wrote. “To the extent Jamison’s interpretation would distinguish between primary and secondary liability, the Exclusion would apply to ePlanning, Inc. differently from how it would apply to ePlanning’s subsidiary insureds, without the policy or the Exclusion distinguishing between ePlanning, Inc. and its subsidiaries.… [T]he Exclusion is not readily susceptible to Jamison’s interpretation.”

To read the Ninth Circuit’s decision in Jamison v. Certain Underwriters at Lloyd’s, click here.

To read the district court’s order, click here.

Pennsylvania Narrows Employer Liability Exclusion

Why it matters: Policyholders scored a victory in Pennsylvania when the state’s highest court ruled that the employer’s liability exclusion in an umbrella commercial liability insurance policy had limited scope due to basic grammar rules concerning the use of definite and indefinite articles in the policy provision.

A restaurant bought an umbrella liability policy that included an employer’s liability exclusion, which applied to injury to “an employee of the insured arising out of and in the course of [the employee’s] employment by the insured.” The policy also included language providing that the policy applies “separately to each insured against whom claim is made or suit is brought.”

The restaurant operates on leased property, and the lease agreement required the restaurant to include the property owners as additional insureds on the liability policy. A restaurant employee was injured in 2007 and sued the property owners, who requested a defense from the restaurant’s insurance carrier. The insurer denied the request for defense and indemnification based on an exclusion for “employer’s liability,” arguing that the injured employee was in the “employment of the insured,” because the property owners were an “insured” under the policy. The Pennsylvania Supreme Court rejected the insurer’s reading, finding that it was ambiguous whether “the insured” in that context included more than the injured person’s employer or, more expansively, applied to “any insured.” Because the property owners did not employ the injured party, the exclusion did not apply.

As such, Pennsylvania policyholders can rest assured that insurers will be bound strictly to the language of their exclusions and not be permitted to expand their reach through broad interpretations of unclear language.

Detailed discussion: Christos Politsopoulos and Dionysios Mihalopoulos leased their property to Leola Restaurant. The lease required that the property owners be named as additional insureds on the restaurant’s liability policy. While the owners were not specifically designated on the declarations page, the policy was designed to extend coverage to unidentified persons doing business with Leola with whom the restaurant agreed in writing to provide insurance.

In December 2007, a Leola employee fell from an outside set of stairs and was injured. She sued the property owners, alleging they were negligent in maintaining the stairs in an unsafe and dangerous condition.

The property owners sought defense and indemnification from Mutual Benefit Insurance Company pursuant to Leola’s umbrella commercial liability insurance policy. The insurer denied the request, relying upon an employer’s liability exclusion that prohibited coverage pertaining to liability for injury to “[a]n ‘employee’ of the insured arising out of and in the course of … [e]mployment by the insured[.]” Mutual Benefit argued that the policy’s broad definition of “insured” encompassed the property owners and that the exclusion therefore applied.

In response, the property owners countered that the exclusion was unclear and ambiguous because it used the term “the insured” as opposed to “any insured” to refer to the particular insured against whom a claim is asserted. They also pointed to a Separation of Insureds provision that stated the policy applied “[s]eparately to each insured against whom claim is made or suit is brought.”

The property owners filed suit and the trial court judge granted the insurer’s motion for summary judgment. The trial court believed it was bound by Pennsylvania Manufacturers’ Association Insurance Co. v. AETNA Casualty & Surety Insurance Co., 426 Pa. 453, 233 A.2d 548 (PMA). An appellate panel reversed.

The Supreme Court, however, found PMA distinguishable and joined the majority of jurisdictions to take a narrower view of the employer’s liability exclusion pertaining to employees of “the insured.”

“[A] majority of jurisdictions recognize potential differences in meaning which may be taken from the selective use of definite and indefinite articles in association with the word ‘insured’ as employed in insurance policy exclusions,” the Pennsylvania Supreme Court explained. “Such potential differences, where recognized by the courts, have been taken to reflect ambiguities, thus requiring construction of salient policy language on the terms most favorable to the insured.”

The court cited decisions from jurisdictions including Iowa, Louisiana, North Carolina, Maine, Michigan, and Ohio.

PMA departed from this line of reasoning, the court said.

“Upon consideration of the broader range of authorities and the reasoning which they provide—which were not overtly considered in PMA—we decline to extend PMA’s expansive construction of the term ‘the insured’ to an instance in which a commercial general liability policy variously makes use of the terms ‘the insured’ and ‘any insured,’” the court wrote. “Rather, we are persuaded that, at least where a commercial general liability policy makes varied use of the definite and indefinite articles, this, as a general rule, creates an ambiguity relative to the former, such that ‘the insured’ may be reasonably taken as signifying the particular insured against whom a claim is asserted.”

The separation of insureds clause only served to reinforce this understanding, the court added, although other indications and contextual cues appearing in an insurance policy may serve to render the meaning of “the insured” more apparent.

Concerns expressed by the insurer that this would result in “double payment” for employees with coverage from an employer’s insurer as well as workers’ compensation did not sway the court. This public policy argument “downplays both the diversity in the interests present and the potential impact of an employer’s subrogation rights relative to workers’ compensation payments,” the court said.

“In summary, we conclude that the employer’s liability exclusion in the umbrella policy is ambiguous,” the court wrote. “Application of governing principles of insurance policy construction yields the understanding that the ambiguous exclusionary language pertains only to claims asserted by employees of ‘the insured’ against whom the claim is directed. ... Since the Property Owners are not [the injured plaintiff’s] employers, the employer’s liability exclusion is inapplicable.”

To read the opinion in Mutual Benefit Insurance Co. v. Politsopoulos, click here.

Guilty Pleas By Executives Allow D&O Insurer To Recoup Costs

Why it matters: The U.S. Court of Appeals for the Fourth Circuit held that, where a D&O policy expressly required reimbursement of defense costs incurred on behalf of insureds who ultimately are found guilty of fraud, the reimbursement provision was triggered when four executives pleaded guilty.

The insured company was served with multiple subpoenas and search warrants in early 2012, followed by notification that the company was under investigation by the Department of Justice. Four executives—including the company’s president and chief executive officer—entered into plea agreements admitting they “willfully, knowingly” engaged in fraud. The company’s insurer, which had been providing coverage for defense costs, requested repayment, arguing that the guilty pleas triggered multiple policy exclusions and reimbursement provisions. A federal court judge granted summary judgment in favor of the insurer, ordering the policyholder to pay roughly $900,000. The Fourth Circuit affirmed.

This case shows the need to be aware of policy wording when buying coverage.

Detailed discussion: Protection Strategies, Inc. (PSI), a global security management and consulting company, received subpoenas from the NASA Office of the Inspector General and a search and seizure warrant from the U.S. Attorney’s Office in the Eastern District of Virginia in January 2012.

The warrant sought evidence of a host of illegal activity, including false claims, conspiracy, mail fraud, wire fraud, and false statements to the Small Business Administration (SBA) with regard to the Section 8(a) program. When the warrant was executed, several of PSI’s current and former officers were informed they were also individual targets of the investigation.

PSI notified insurer Starr Indemnity & Liability Company of the investigation. Starr responded with a reservation of rights letter and began reimbursing PSI for the defense costs the policyholder incurred indemnifying its officers. The individual PSI officers were represented by separate counsel throughout the investigation, and the company retained its own counsel.

The insured filed a declaratory action seeking an order that Starr had a duty to defend and indemnify. Starr initially argued that the search warrant and subpoena did not create a “claim” under the Directors & Officers Liability (D&O) section of the policy, but the court ruled that they did create a claim even in the absence of a formal criminal prosecution. Starr continued to reimburse PSI for its defense costs.

In 2013, four of PSI’s officers—including the company’s chief executive officer—entered plea agreements in Virginia federal court to crimes including major fraud against the United States, conspiracy to commit fraud, and bribery in connection with PSI’s SBA program. Each of the pleas stipulated that the officer knowingly and willfully took actions in furtherance of this fraud.

When Starr learned of the guilty pleas, the insurer counterclaimed in the coverage suit, seeking recoupment for all defense costs.

A federal district court judge ruled that in the wake of the PSI officers’ guilty pleas, the entire investigation fell within the policy’s exclusions, operating as a complete bar to coverage.

Section 3 of the D&O policy provided the following:

“This policy shall not cover any Loss in connection with any Claim … (a) arising out of, based upon or attributable to the gaining of any profit or advantage or improper or illegal remuneration if a final judgment or adjudication establishes that such Insured was not legally entitled to such profit or advantage or that such remuneration was improper or illegal; (b) arising out of, based upon or attributable to any deliberate fraudulent act or any willful violation of law by an Insured if a final judgment or adjudication establishes that such act or violation occurred; … (d) alleging, arising out of, based on or attributable to any facts or circumstances of which an Insured Person had actual knowledge or information of, as of the Pending or Prior Date set forth in Item 6 of the Declarations as respects this coverage section, and that he or she reasonably believed may give rise to a Claim under this policy.”

Each of these three exclusions applied, the court said: Section (a)’s profit exclusion, Section (b)’s fraud exclusion, and Section (d)’s prior knowledge exclusion. In addition, the CEO signed a warranty and representation letter attached to the policy that also operated to bar coverage.

The fraud and profit exclusions “unambiguously apply to the Claims in this case,” U.S. District Court Judge Liam O’Grady wrote, with the CEO’s plea agreement clearly establishing that PSI and its executives “knowingly, intentionally, and improperly gained an advantage and illegal remuneration of at least $31 million by fraudulently creating [a shell company] and representing it was eligible for the SBA Section 8(a) program.”

The prior knowledge exclusion also operated to bar coverage, as each of the four PSI officers had actual knowledge of the ongoing scheme to defraud the government, the court said, and should reasonably have believed that a claim would result under the D&O policy.

The claim against PSI itself was excluded, as the language of the prior knowledge exclusion provided that any claim was excluded when it arose from facts of which an insured person was aware and was not limited to the specific claim against that particular insured person.

As for the warranty letter, Judge O’Grady said it became part of the application on which Starr relied when it sold the policy, even though it was signed nine days after the policy went into effect.

PSI bargained for more D&O coverage and Starr conditioned the enhanced coverage on execution of the letter, which represented that “[n]o person or entity proposed for insurance under the policy referenced above has knowledge or information of any act … which may give rise to a claim(s), suit(s) or action(s) under such proposed policy.”

“PSI cannot dispute that [the CEO] made a material misrepresentation when he certified in the letter that ‘no person’ at PSI had knowledge of facts that might give rise to a Claim,” the court wrote. “Because Starr relied on [the CEO’s] misrepresentation when it granted the final 2011 D&O Policy, the terms of the Warranty Letter preclude coverage for the entire investigation against PSI and its officers.”

Turning to recoupment, the court found it was an appropriate remedy, particularly as the policy expressly provided for recoupment as a remedy in Section 6 of the general terms and conditions. “Because PSI was not entitled to coverage for any losses arising out of these Claims … the recoupment provision applies,” Judge O’Grady said.

While a split exists among jurisdictions regarding whether a reservation of rights letter is sufficient to reserve a right to recoupment, case law uniformly suggests that recoupment is an available remedy when it is expressly written into the policy, the court explained, citing decisions from Arkansas, Idaho, Pennsylvania, and the Tenth Circuit.

PSI’s contention that Starr could not recoup any of the uncovered losses for which it had already reimbursed PSI when the judgment became final stood in opposition to the clear language of the policy, which stated that it did not cover “any Loss in connection with” an excluded claim, the court explained.

The district court ordered PSI to reimburse Starr $846,483.34 for defense costs, as well as pre- and post-judgment interest.

PSI appealed, but the Fourth Circuit Court of Appeals affirmed in an unpublished opinion.

The panel rejected PSI’s argument that the district court impermissibly resolved issues of fact regarding the circumstances under which the warranty letter was executed and agreed with the lower court that the exclusion for prior knowledge was applicable.

PSI also tried to at least minimize the recoupment by arguing that the profit and fraud exclusions should not operate to bar defense costs for three other officers who did not plead guilty, but the court disagreed. “[T]he exclusions were applicable to bar coverage for these individuals as a result of the guilty pleas of PSI’s former chief executive officer and chief financial officers,” the panel wrote.

The court made quick work of PSI’s challenge to the recoupment order, finding it “unsupported by the record and otherwise without merit.”

To read the district court decision in Protection Strategies, Inc. v. Starr Indemnity & Liability Co., click here.

To read the Fourth Circuit’s opinion, click here.