Archive for July 2017


When does a prior acts exclusion apply to future wrongful acts?

July 6th, 2017 — 5:11pm

by Christopher Graham and Shelly Hall

It’s 2008. The subprime lending crisis begins. You’re an officer of a bank holding company. It’s approaching insolvency. It’s also facing a class-action by its investors. And regulators are investigating its subsidiary bank for “unsafe and unsound practices” in mortgage lending. Another officer transfers $80 million in new capital to the subsidiary to keep it afloat.

There’s a D&O insurance policy which, subject to its terms, covers the holding company and subsidiary, and their directors and officers including you. Unfortunately for you, that D&O insurer wants off the risk and provides a notice of non-renewal.

But your company’s broker finds another D&O insurer offering alternative terms including: (1) for a $350,000 premium, $10 million in limits and a “prior acts” exclusion, applicable to “Loss in connection with a Claim arising out of… any Wrongful Act committed or allegedly committed, in whole or in part, prior to [November 10, 2008],” the policy inception date; (2) for a $650,000 premium, $10 million in limits, but with no prior acts exclusion; and (3) at your company’s request, for a $700,000 premium, $20 million in limits, but also with a prior acts exclusion.

Which option do you want? Easy answer: the one that wasn’t offered—namely, without the prior acts exclusion and with $20 million in limits. Which option does the company pick? $20 million in limits and prior acts exclusion. So how does that choice work out for you?

After the new D&O policy incepts, the subsidiary needs even more money to stay afloat; so in early 2009, you and another officer transfer—in two installments–$46 million of holding-company tax refunds to the subsidiary. Not enough. Regulators shut down the subsidiary bank, and a receiver is appointed. The holding company files for a reorganization under Chapter 11 of the United States Bankruptcy Code. Not good. What happens next?

An administrator is assigned for the holding company’s Chapter 11 bankruptcy plan. He sues you and the two other officers. He alleges you all breached fiduciary duties thereby causing the holding company and subsidiary to fail, and prolonging their existence leading to greater losses. He alleges misconduct by the officer who transferred $80 million to the subsidiary before the new D&O policy’s inception, and seeks to recover $80 million in damages from him. And he alleges that by transferring $46 million in tax-refunds to the subsidiary after the D&O policy’s inception, you and another officer violated the Florida Fraudulent Transfer Act; the transfers allegedly occurred when the holding company was insolvent or it became insolvent as a result of the transfers, and without receiving reasonably equivalent value in exchange.

You notify the D&O insurer. The response: coverage denied; it’s because of the prior acts exclusion—they say. Now what?

You want out. You settle. Under one of the settlement agreements — apparently, an attempt to avoid the prior acts exclusion—you and the other officers resolve the administrator’s claim involving the post-November 10, 2008 tax-refund transfers occurring after the D&O policy’s inception. The post-November 2008 transfer settlement is for $15 million “to be paid [to the administrator] by either” the D&O insurer or you and the other two officers. Under that agreement, you and the other officers also assign all rights under the D&O policy to the administrator, who then sues the D&O insurer. Who wins?

In a case generally along these lines, the Eleventh Circuit in Zucker v. U.S. Specialty Insurance, Case No. 05-1097 (11th Circuit May 16, 2017) says the D&O insurer. Why? Because the prior acts exclusion applies. Under that exclusion, the D&O insurer has no obligation to pay “Loss in connection with a Claim arising out of, based upon or attributable to any Wrongful Act committed or allegedly committed, in whole or in part, prior to [November 10, 2008].”

But the settled count is based on an alleged fraudulent transfer that occurred in 2009—not before November 10, 2008. Doesn’t that matter? No, says the Court: the “insolvency” of the holding company “is an element of [the administrator’s fraudulent transfer act] claim [involving the 2009 transfer] and that insolvency has a connection to misdeeds and misdealing of the … officers before November 2008.”

Under Florida law, the phrase “arising out of,” as used in the prior acts exclusion, “is not ambiguous and has a broad meaning, even when used in a policy exclusion; ‘arising out of’ is more than ‘mere coincidence,’ but less ‘proximate cause’, and means ‘originating from,’ ‘having its origin in,’ ‘growing out of,’ ‘flowing from,’ ‘incident to’, or ‘having a connection with.’” The fraudulent transfer act claim, about the 2009 transfer, thus, arose out of pre-November 10, 2008 Wrongful Acts.

According to the Court, it didn’t matter that the administrator — presumably to avoid the prior acts exclusion — chose not to incorporate into the fraudulent transfer count certain prior allegations describing the officers’ pre-November 10, 2008 misconduct.

That the prior acts exclusion applied to claims arising from post-November 10, 2008 wrongful acts—here, the 2009 transfer to the subsidiary—moreover, didn’t mean that the D&O policy’s coverage was illusory as the administrator argued. As the Court explained, the “Prior Acts Exclusion does not “grant [a] right[] in one paragraph and then retract the very same right” in a later one. [Citation omitted]. Instead, it simply excludes coverage for a subset of claims that would ordinarily fall within the policy’s insuring provisions.”

According to the Court, the holding company “entered into the [D&O policy] with its eyes wide open and its wallet on its mind.” The administrator “believe[d] that the [holding company] did not get a good deal and wishe[d the holding company] had paid a higher premium for a policy without a Prior Acts exclusion.” But “after the fact wishes are not enough to change before the fact choices.”

Comments: The Court suggests that the holding company had its wallet on its mind in choosing the D&O policy with a prior acts exclusion. But, as far as we can tell, that option actually was the most expensive one—presumably because it included double the limits of the other two options. But when a financially troubled company chooses a D&O policy with double limits with a prior acts exclusion with “arising out of” wording, are the double limits really worth foregoing the lower-limit option without a prior acts exclusion? What are you really getting, especially since the lower-limit option without a prior acts exclusion cost $50,000 less? In this case, not much.

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