“Moral hazard,” “reasonable expectations,” and D&O insurance for contractual liability

by Christopher Graham and Joseph Kelly

New Jersey

One day a policyholder affiliate’s CFO signed foreign exchange transaction agreements with several banks. The banks later demanded what was allegedly due under them. The policyholder and insured affiliate demanded that their D&O insurer defend the claims and indemnify them for any payment. They alleged that the CFO committed wrongful acts by entering into the agreements without authority. After the D&O insurer denied coverage, the policyholder and affiliate settled several claims. And then they sued the D&O insurer. Who wins?

In PNY Technologies, Inc. v. Twin City Fire Ins. Co., Case No. 11-4547 (SRC) (D. N.J. July 16, 2014), the Judge said the insurer wins.

Typical of D&O policies, this policy had a version of a contract liability exclusion. This one excluded coverage for any claim:

based upon, arising from, or in any way related to any actual or alleged … liability under any contract or agreement, provided that this exclusion shall not apply to the extent that liability would have been incurred in the absence of such contract or agreement.

In granting the insurer a summary judgment, this Judge concluded that the banks’ claims fell squarely within that exclusion: “the claims arose from liability under the foreign exchange agreements, and there would be no claims or liabilities absent those agreements.”

This Judge also held that the banks’ claims fell outside the policy’s insuring agreement for entity coverage. Under that agreement, subject to the policy’s terms and conditions, this insurer agreed to “pay Loss on behalf of an Insured Entity resulting from an Entity Claim … for a Wrongful Act by an Insured Entity.” “Wrongful Act” meant “an actual or alleged act, error, omission, neglect, breach of duty, misstatement or misleading statement by the Company.”

The policyholder and affiliate argued that the CFO committed a “Wrongful Act” by entering into the exchange agreements with the banks, supposedly without authority. But their problem, according to the Judge, was that Entity Coverage was limited to “Loss . . . resulting from an Entity Claim … for a Wrongful Act by an Insured Entity.” The banks didn’t allege a Wrongful Act by an Insured Entity. The banks weren’t even alleging a Wrongful Act by the CFO; the policyholder and affiliate were alleging those wrongful acts.

But what about their failure to pay the banks under the exchange agreements? Didn’t the banks allege breaches by the policyholder and affiliate? Why wouldn’t those breaches qualify as “Wrongful Acts”?

The opinion doesn’t discuss those points. And, given the contractual liability exclusion, the policyholder and affiliate would have lost the case, even if the banks’ allegations of breach by the entity amounted to an “Entity Claim … for a Wrongful Act by an Insured Entity.”

Although this Judge’s decision was based upon insurance contract wording, he also raised the problem of “moral hazard”. If you can commit bad acts with no consequence then there’s no incentive to be good. If you can promise to pay, but not worry about making the payment yourself, then you have no reason to pay. If you can insure the consequences of breaking a promise, then there’s no incentive to keep your promise.

And he’s not the first judge to raise the issue. In reaching his decision, this Judge quoted none other than Judge Richard Posner, a Federal appeals court judge, economist, and prolific writer about law and economics, who often incorporates economic concepts into his opinions.

Here’s Posner’s “moral hazard” quote, from a case about employment practices liability insurance:

[I]nsurance policies are presumed not to insure against liability for breach of contract. The reason is the severe “moral hazard” problem to which such insurance would often give rise. The term refers to the incentive that insurance can create to commit the act insured against, since the cost is shifted to the insurance company. An example is the incentive to burn down one’s house if the house is insured for more than its value to the owner. Or suppose, having somehow persuaded an insurance company to insure you against liability for breach of contract, you hire a contractor to build an extension on your house and after he has completed his work you refuse to pay him, and, when he sues, you turn the claim over to the insurance company.

Krueger International, Inc. v. Royal Indemnity Co., 481 F.3d 993, 996 (7th Cir. 2007).

So insuring claims for contract breaches is “immoral,” right? That’s not quite what Judge Posner or this Judge said. The EPL policy addressed by Posner covered breach of an oral employment agreement, but losses attributable to breach of a written contract were excluded. Posner explained that “breach of a written contract often will be a deliberate act by the insured, while the breach of a contract created by oral representation of an employee is likely to be, from the insured’s standpoint, an unavoidable accident.” Said Posner in addition, “The difference lies in the nature of the act that precipitates the breach: a deliberate decision by the insured, on the one hand, and the careless or unauthorized act of an employee on the other.”

Despite his concerns about moral hazard, Judge Posner’s decision–finding no coverage–was about policy wording: “As there was neither a breach of an oral employment agreement nor misrepresentation [(also an insured act)], there was no insurable act . . . .”

Numerous decisions allow coverage for breach of contract claims, depending on the policy wording. See, e.g., 1325 North Van Buren, LLC v. T-3 Group, Ltd., 716 N.W.2d 822 (Wis. 2006) (coverage for breach of contract claim for insured who allegedly failed to provide competent professional services).

And despite concerns about “moral hazard”, the Judge in the PNY Technologies case also based his decision on contract wording.

So did “moral hazard” make any difference? Without the right policy wording, the insurer would have lost. The Judge also rejected a policyholder/affiliate argument–based on their so-called “reasonable expectation” of coverage–initially because the “reasonable expectations” rule under New Jersey law didn’t apply where, as in this case, there was no ambiguity in the policy wording.

But with moral hazard in mind, this Judge also didn’t otherwise take the “reasonably expectations” argument seriously. After setting forth the quote from Judge Posner’s opinion noted above, this Judge stated, the policyholder and affiliate “seem to contend that they expected their insurance policy to offer coverage that would give rise to such moral hazards,” but they “have not shown this to be objectively reasonable.” And that certainly was the case!

Tags: D&O, management liability insurance, directors and officers liability insurance, moral hazard, New Jersey, breach of contract, wrongful act, contractual liability exclusion, entity coverage, employment practices liability insurance, EPL, reasonable expectations

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