Some coverage exclusions are so broadly written that it can be challenging for courts to keep them in their proper place. The problem might be that insurance companies were permitted to use such exclusions in the first place.

It is a truism of insurance law that a court should not interpret or apply a policy exclusion such that it renders the coverage illusory.

With that general principle in mind, every Board member, General Counsel, and Risk Manager of a company that has Directors’ & Officers’ Liability coverage should pay close attention to two particular policy provisions.  In some policies, it is called the “Interrelated Wrongful Acts” clause.  In others, it might be a similarly worded “Prior and Pending Proceeding” exclusion.  A recent decision by the United States District Court for the District of Maryland is a reminder of how these provisions, if construed as broadly as carriers often argue that they should be construed, can be quite pernicious and can nullify coverage that a policyholder would have reasonably believed it had in place.

The terms of D&O policies vary from carrier to carrier to a greater extent than most other liability insurance policies sold in the United States.  That said, essentially all D&O policies are written on a claims-made-and-reported basis, which means that coverage only applies if the potentially covered claim against the insured is made during the policy period and if the insured also reports the claim to the carrier during the policy period.  For a claims-made policy, the end of the policy period is (with certain exceptions not really relevant to this discussion) a hard-stop on the carrier’s coverage obligations.

Often — perhaps we might even say, “most of the time” — the events that gave rise to the claim against the insured happened before the policy period.  It’s a fairly rare claim against a director or officer of a company where the alleged wrongful act results in the immediate filing of a complaint or a demand by the injured party.  There’s usually some lag time between the two.  (For this reason, and not to get too far off-topic, it is a best practice for a policyholder to give the carrier what is called a “notice of circumstances” whenever an act or event involving an officer or director could potentially result in a claim being made against the company.)  As long as the insured doesn’t hide from the carrier an act or circumstance that might eventually lead to a claim or lawsuit against an officer or director, the carrier should be obligated to cover a pre-policy “wrongful act” that results in the filing of a claim or lawsuit against the insured during the policy based upon the pre-policy behavior.

You might think that it should always be relatively easy to figure out whether a prior claim was “interrelated” with the later claim for which the insured is seeking coverage.  And you’d be wrong.

But sometimes a claim or lawsuit during the policy period “relates” in some way to a previously filed claim or suit.  And that’s where the potentially nasty exclusions may come into play. Most D&O policies have some form of an “Interrelated Wrongful Acts” provision.

Again, language can vary, but the provision typically says that more than one claim involving “interrelated wrongful acts” will be considered one claim and that such a claim will be deemed to have been made on the first date on which the earliest such claim was made.  Since a covered claim is one that is both made against the insured and reported to the carrier during the policy period, if a claim involving an “interrelated wrongful act” occurs before the policy period in which the insured gave notice, the carrier is sure to argue that the claim during the present policy is not covered.  (Also, as mentioned, the troublesome provision is sometimes called a “Prior and Pending Proceeding” exclusion; and, although the PPP exclusion is often tied to a “retroactive date” that provides a pre-policy grace period of sorts for the timing of the prior claim, the language and effect of the PPP exclusion and the “Interrelated Wrongful Acts” provision present essentially the same coverage problem.)

You might think that it should always be relatively easy to figure out whether a prior claim was “interrelated” with the later claim for which the insured is seeking coverage.  And you’d be wrong.

The uncertainty arises because both the PPP exclusion and the “Interrelated Wrongful Acts” clause define “interrelated” incredibly broadly.  For example, a common definition of “Interrelated Wrongful Acts” is “any Wrongful Act that is logically or causally connected by reason of any common fact, circumstance, situation, transaction or event.”  This definition fairly begs an insurance company’s lawyer to argue that a previous lawsuit has something – anything, really — in common with the lawsuit for which the insured seeks coverage.

It’s worth pausing for a moment here to consider a rule of insurance policy interpretation.  In every jurisdiction, courts are supposed to interpret policy exclusions narrowly and strictly in favor of the insured.  So, if there is any reasonable interpretation of an exclusion that could result in finding that it is inapplicable to a circumstance under consideration, the court should adopt that interpretation.

When courts recite the rule that insurance policies are simply contracts that must be interpreted like any other contract, and they fail to recite the associated principle that exclusions must be narrowly construed, it’s usually a clue that the policyholder is about to lose.

This creates challenges for courts when the exclusion is worded so broadly that it makes it hard to conceive of a set of facts to which the exclusion wouldn’t apply. Consider, for example, the phrase under discussion, “any common fact, circumstance, situation, transaction or event.”  Apply that phrase literally and every lawsuit involving an insured is “interrelated” to every other lawsuit involving the same insured — the common “fact, circumstance, or situation” being that the insured is a party in both lawsuits.  While no court — thankfully — has ever applied the “Interrelated Wrongful Acts” provision in that way, one might, philosophically at least, ask, “Why not?”  After all, the language of the provision, viewed in a perfectly literal way, supports such a result.

The answer probably lies, at least in part, in a court’s abhorrence of absurdity. The First Amendment to the U.S. Constitution says, “Congress shall make no law … abridging the freedom of speech.”  This should mean that making a law that prohibits yelling, “Fire!” in a crowded theatre violates the First Amendment.  Except that we know it doesn’t.

Similarly, “any common fact, circumstance, situation, transaction or event” cannot possibly mean what it literally appears to mean. There are, of course, other words in the provision to consider that might serve to limit or define its scope.  The “wrongful acts” at issue must be “logically or causally connected by reason of” the common fact, circumstance, etc., of the prior “wrongful acts.”  In the abstract, though, it is still devilishly hard to figure out how to determine if someone’s act is “logically or causally” connected to a later fact, circumstance, situation, transaction or event.  The task becomes no less difficult, unfortunately, when there are concrete facts to apply to the provision. Take, for example, the case W.C. and A.N. Miller Development Co. v. Continental Casualty Co., Case No. GJH-14-00425 (D.Md Nov. 7, 2014).  (Get a copy here.)

International Benefits Group signed a contract with Haymount Limited Partnership in which it agreed to help HLP find financing for a real estate project. In return, if HLP obtained financing for the project from a lender introduced to it by IBG, HLP was supposed to pay IBG a $3 million finder’s fee.  IBG made an introduction to HLP that ultimately resulted in financing for the project.  HLP then refused for various reasons to pay the finder’s fee.  The refusal to pay allegedly drove IBG into bankruptcy.

The IBG Bankruptcy Trustee then sued HLP in what’s called an “Adversary Proceeding” to recover the finder’s fee for IBG’s bankrupt estate.  That proceeding formed the basis of a later denial of coverage under an “Interrelated Wrongful Acts” clause in HLP’s D&O policy. In the Adversary Proceeding, which was filed in 2006, the Trustee made claims against HLP for breach of contract, unjust enrichment, tortious interference with contract, and conspiracy.  It’s worth noting that the 2006 HLP D&O policy contained an exclusion for claims of breach of contract.  So, even though the Adversary Proceeding fell within the policy definition of a covered “Claim,” the breach-of-contract exclusion precluded coverage for it.

The Trustee won a $4.4 million judgment against HLP in the Adversary Proceeding, which he then went about trying to collect.  To that end, he filed a lawsuit in 2010 against HLP in federal court in New Jersey, in which he claimed that HLP and its principals had been attempting to hide the company’s assets from the Trustee in an effort to avoid paying the $4.4 million judgment.  If proved, such actions could violate the law in several ways. The Trustee’s 2010 lawsuit made claims of fraudulent transfer, fraudulent conveyance, creditor fraud, aiding and abetting, and conspiracy.  Observe that none of these causes of action are the same as the ones the Trustee made in the 2006 Adversary Proceeding that had resulted in entry of the $4.4 million judgment.

It’s easy to see where this is going. HLP tendered the 2010 lawsuit to its D&O carrier, Continental Casualty Company (which is known as “CNA”).  The carrier denied on the ground that the 2010 lawsuit involved interrelated wrongful acts that were part of the 2006 Adversary Proceeding; that those interrelated wrongful acts formed the basis of a “Claim” that was first made against HLP in 2006 rather than in 2010; and therefore the Claims in the 2010 lawsuit were not first made and reported to CNA in 2010.  HLP then sued CNA for coverage.

CNA made a motion for summary judgment in the coverage action, which the Court granted on the basis of the Interrelated Wrongful Acts provision.  What is interesting about the decision is that the Court did not appear to struggle with the concept that exclusions in coverage are supposed to be narrowly construed in favor of the policyholder.  In fact, the Court did not even cite the rule.  (Although the “Interrelated Wrongful Acts” provision is not generally listed in the “Exclusions” section of the policy, it obviously acts as an exclusion and should be treated as one when determining how to apply it.)

When courts recite the rule that insurance policies are simply contracts that must be interpreted in accordance with their plain and ordinary meaning, and they fail to recite the associated principle that exclusions must be narrowly construed, it’s usually a clue that the policyholder is about to lose. CNA’s argument, which the Court adopted, was that the wrongful act “at the core” of the Trustee’s 2006 Adversary Proceeding was the alleged conspiracy of the principals of HLP to avoid paying the IBG finder’s fee and that this was the same wrongful act “at the core” of the 2010 collection lawsuit.

Had the Miller Court sought to apply the Interrelated Wrongful Acts clause narrowly, it could easily have done so in this case.

In siding with CNA, the Court found that the 2006 proceeding and the 2010 lawsuit involved “a common scheme” to deprive IBG of its finder’s fee.  Note that the Interrelated Wrongful Acts clause does not use the word “scheme.”  The actual words used are “common fact, circumstance, situation, transaction or event.” The policyholders argued that there were significant differences between the claims and facts in the 2006 Adversary Proceeding and the claims and facts in the 2010 lawsuit, a point that the Court acknowledged to be true.

It is, in fact, not hard to see how the two actions differed from one another, even without having the benefit of sitting through the presentation of evidence in the 2006 Adversary Proceeding. The original action must have involved proof of the existence and terms of the contract.  It must have been shown that there was an introduction made to HLP that resulted in financing the HLP project and that HLP rejected IBG’s demand for payment of the finder’s fee.  HLP, presumably, raised defenses to the claim for payment.  For example, one of the facts recited in the Miller decision was that the financier who was originally introduced by IBG was not the one who actually provided the financing.  The financing actually resulted from a further introduction to another financier and that subsequent introduction had not directly involved IBG.

The 2010 lawsuit, on the other hand, appears to have involved allegations of activities HLP subsequently took to avoid collection of the $4.4 million judgment.  That claim, presumably, would involve introduction of evidence that had little or nothing to do with the original transaction but, instead, would require proof that HLP began shedding its assets at some point after entry of the judgment.  Those wrongful acts, if they occurred, would not be at all the same acts that HLP engaged in when it rejected the finder’s fee.  In other words, had the Miller Court sought to apply the Interrelated Wrongful Acts clause narrowly, such that it would apply only if the actual activities the policyholder undertook were the same in both cases, it could easily have done so in this case.

Yet, the Court rejected the notion that the differences between the two actions were even relevant, holding instead that “the relevant focus is not on any number of differences between the 2006 Adversary Proceeding and the 2010 Lawsuit; instead, the relevant focus is on the similarities between the two.”  While this approach may follow from the word “any” that appears in the clause, it does set up something of a self-fulfilling prophecy of interpretation.  If there are 1,000 differences and one similarity, the focus on similarities ensures that the later claim will be excluded.

The Miller Court also noted that the clause requires that the “common” attributes of the two claims must be either “logically or causally” connected.  It then found, in conclusory fashion, that it was “entirely logical that the Trustee would institute the 2010 Lawsuit against HLP, Mr. Miller, and others to recover damages associated with alleged actions taken by them to avoid paying the judgment issued in the 2006 Adversary Proceeding.”  The Court is, of course, not actually applying “logic” to the question.  Logic isn’t the right word for the statement the Court makes here.  The right word would be “rational,” which is not at all the same thing as “logical.” To apply logic to this analysis, the Court would have had to inquire whether there was any possible situation in which all of the premises of CNA’s arguments were true but the conclusion false.

The Court didn’t engage in this analysis, most likely because of sloppiness in the use of language: it was sloppy of the insurer to use the word “logically” when what it clearly meant was “rationally” and it was sloppy of the Court to fail to recognize the difference.

The problem ultimately arises from the breadth of the language of the Interrelated Wrongful Acts clause and the temptation on the part of courts to apply the language literally instead of attempting to cabin the circumstances to which the provision might apply.

Except in fairly narrow circumstances, all of the language insurance companies seek to include in their policies has to be approved beforehand by each state’s Insurance Commissioner.  The approval process is supposed to protect the public from exclusions and limitations that deprive policyholders of coverage essential to the bargain or that give insurance companies a windfall in premiums for coverage that is unreasonably narrow.

If courts frequently have difficulty applying the excessively broad language of the Interrelated Wrongful Acts clause in a way that does not swallow up much of the coverage an average policyholder reasonably expects from its policy, then perhaps the root of the problem is that Insurance Commissioners ever approved the language of the clause in the first place.