I have often described the “conduct exclusions” in a D&O policy as having a bark far worse than their bite on insureds. That is particularly so when they require a final and unappealable adjudication to take place in the same underlying proceeding as constitutes the claim submitted for coverage. Most policies written now have such wording, but a recent decision interpreting the so-called “in fact” wording should make policyholders and brokers appreciate even more the strength and benefit of final adjudication language.

In Farkas v. National Union Fire Ins. Co. of Pittsburgh, PA, 2011 U.S. Dist. LEXIS 75972, Docket No. 1:11-cv-00529 (E.D. Va., Decided July 14, 2011), the Court had the opportunity to consider both a personal profit and dishonesty exclusion with “in fact” language.

The underlying claim in Farkas was an indictment for conspiracy to commit bank, wire and securities fraud against the chairman of a corporation. The insurer began to pay defense costs under a reservation of rights in response to the indictment, which constituted a covered claim under the policy. Upon conviction on all counts, the insurer, relying upon the “in fact” trigger in the exclusions, declined to make any further defense payments and reserved the right to seek reimbursement of amounts already paid.

The Court found that the exclusions were clearly triggered by the jury’s guilty verdict. Indeed, the Court noted that the criminal standard of “proof beyond a reasonable doubt” was much greater than “some pertinent factual finding” that other courts had held sufficient to trigger similarly worded exclusions. The insured argued that the insurer should be compelled to pay costs through an appeal of the convictions, but the Court rejected this on the basis that “[the] policy does not require payment of defense costs for a claim that is not covered by the policy.”

The insured also raised some interesting equitable and public policy arguments, and I commend the reader to review the entire decision [here].

Here, the underlying claim was the criminal proceeding itself. What the Court did not have before it was the quite common situation where there is a criminal conviction while a civil suit based upon similar allegations is pending. That situation, however, would likely not be excluded under the most prevalent versions of the conduct exclusions in use today. The following is an example of current wording.

The Insurer shall not pay Loss in connection with that portion of any Claim made against an Insured Person for any Wrongful Act, or against the Company for a Securities Wrongful Act, that is for:

(1)  deliberately fraudulent, or deliberately criminal act or deliberately fraudulent or deliberately criminal omission or any deliberate violation of any statute, rule, or law by the Company or an Insured Person; or

(2)  profit or remuneration gained by the Company or any Insured Person to which she, he or it is not legally entitled. This subparagraph D.(2) exclusion shall not apply with regard to any portion of a settlement or judgment that is predicated on liability arising under Section 11, 12 or 15 of the Securities Act of 1933 or any amendments thereto;

provided that the acts or conduct underlying the foregoing exclusions in this Section are determined by a final adjudication, after exhaustion of all appeals (including petitions for rehearing), in the underlying action establishes that such Insured Person committed such act, omission or violation, or gained such profit or remuneration. These exclusions shall not be applicable to that part of Loss, which is comprised of Defense Expenses.

Certainly, Farkas would have been decided differently under this wording and serves as a cautionary tale to brokers re the dangers of “in fact” wording. On the other hand, and there is always an “other hand” in insurance coverage, it makes insurers recall wistfully the market conditions that allowed them to employ the “in fact” wording.