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.