A New York court recently held that insurance companies cannot claim that an insured violated a D&O insurance policy and unilaterally disclaim coverage without a final adjudication that the insured actually violated the D&O policy. Absent that final adjudication, the policy remains in effect and the insurance company must advance the attorneys' fees and defense costs, subject to recoupment in the event that it is ultimately determined that the exclusions apply. In an interesting twist, the New York court made this determination after the insured had already been convicted by a jury and ordered to pay $18 million in forfeiture, thus ensuring that the insurance company would never again see the money it would advance (estimated at $5 million).
On August 24, 2010, the insured company provided notice to its insurance company that its officers were being charged with bank, wire and mail fraud. On October 4, 2010, the insurance company refused to advance legal fees under the D&O policy because it claimed that: 1) the false financial statements that the officers were being charged with filing had also been submitted to the insurance company; 2) the insured failed to disclose that the insured company had acquired another company; and 3) the insured knowingly made misrepresentations and omissions on its insurance application. The insurance policy specifically excluded coverage when: 1) misrepresentations on the insurance application were made with the intent to deceive or materially affecting the risk assumed by the insurer and the claim relates to the misrepresentations; and 2) failure to disclose any wrongful acts the insured had prior knowledge prior to a specific date.
Fourteen months later, on December 9, 2011, the president of the insured company filed the lawsuit of Dupree v. Scottsdale Insurance Co., Index No. 653412-2011, seeking a preliminary and permanent injunction requiring the insurance company to pay for his legal fees, challenging the insurance company's unilateral disclaimer of his coverage. The insurance company unsuccessfully attempted to have the matter removed to federal court and thus delayed the preliminary injunction hearing.
In the meantime, on December 30, 2011, a jury found that the president of the insured company was guilty, and a forfeiture order was entered against him was in the amount of $18 million. Five days later, the application for a preliminary injunction for his legal fees was heard. Normally, legal fees are paid by the insurance company as they come due. However, here, the insurance company had not yet paid any of the legal fees. The court granted the preliminary injunction and the insurance company appealed. On appeal, the insurance company argued that: 1) because of the strong evidence pointing to the policy exclusion's being in effect, the insured officer could not show a likelihood of success on the merits; 2) there is no irreparable harm as the trial had already finished and the only issue concerned monetary damages - who would pay for the defense costs; and 3) given the $18 million forfeiture order, the insurance company would not be able to recoup any of the defense costs it would have to advance.
On July 11, 2012, the court upheld the preliminary injunction. The court determined that without a final adjudication as to whether the insured's actions actually violated the exclusions in the insurance policy, the insurance company would be required to advance legal fees. Although there was no irreparable harm to the insured as he had already been convicted, the "direct, immediate and irreparable injury" justifying the injunction was the deprivation of the benefit bargained by the insured through payments of the insurance premium.
Although the circumstances of this case are rather unique, in that an insurance company knew of the insured's conviction before having to advance legal costs, the sanctity of the insurance contract ultimately prevailed. From an insurance company's perspective, the lesson learned is that unilaterally disclaiming D&O insurance coverage will not avoid advancing defense costs, no matter how strong the evidence that the insured's conduct falls under the contract's exclusion (or how strong the evidence is of the insured's guilt). Insurance companies must be proactive in seeking declaratory judgments as to whether the conduct of the insured falls within the insurance policy's exclusions. Only after a final adjudication can the insurance company truly know whether it is on the hook for advancing the legal fees.