Policyholders seeking to obtain Directors & Officers (“D&O”) and many other types of liability coverage are often confronted with the question of whether, apart from agreeing to the terms of the policy, they should also acquiesce to an insurer’s request that they sign a separate warranty letter at the time of policy placement. If faced with such a request, a prospective insured should proceed with caution.
Rather than simply restating conditions in the policy, warranty letters are separate agreements that insurers often try to use to impose different, less favorable, conditions upon the insured. In most circumstances, insurers have no legitimate reason to request this type of separate agreement, when they are already protected pursuant to the policy’s terms and conditions. That being said, even a policyholder who already has signed a warranty letter should be aware that an insurer’s attempt to deny coverage based on the letter may still be improper based on core black letter insurance principles.
The potential pitfalls of signing a warranty letter are illustrated by an October 26, 2009 decision from the Tenth Circuit, Rivelli v. Twin City Fire Insurance Co. (Rivelli II).1 The plaintiffs in Rivelli were directors and officers of a Colorado company, Fischer Imaging, that had purchased excess D&O coverage from Twin City, a large, established insurer.2 The excess policy provided for two layers of coverage, each for $2.5 million. To obtain the second layer, sometimes called “top” coverage, Fischer not only paid an additional premium but also provided Twin City with a letter, signed by one of the Rivelli plaintiffs on May 1, 2002, titled “AN EXPRESS WARRANTY FOR ALL INSUREDS.”3 The letter contained what was, in effect, a relatively broad exclusion relating to the insureds’ “prior knowledge,” providing that “[n]o person or entity for whom this insurance is intended has any knowledge or information of any act, error, omission, fact or circumstance which may give rise to a claim which may fall within the scope of the proposed [top] insurance… ”4
In April 2003, Fischer and other insureds were targeted by two shareholder actions, both of which were eventually dismissed.5 But in June 2005 the Securities and Exchange Commission (SEC) filed a civil enforcement action alleging that the insureds had “engaged in a scheme to fraudulently inflate [Fischer’s] stock price for their personal enrichment” from January 2000 to September 2002.6 By that point, the insureds had run through their primary D&O coverage and the first $2.5 million of excess coverage. When the insureds submitted claims for the second $2.5 million, however, Twin City denied coverage entirely based on the exclusion for prior knowledge in the warranty letter.7 Twin City argued, based on the allegations in the SEC’s complaint, that certain insureds allegedly knew of wrongful activities at Fischer that could give rise to a claim reaching the top coverage at the time the warranty letter was signed.8 These bare allegations, according to Twin City, were sufficient to bring the entire SEC enforcement action within the scope of the letter’s exclusionary effect, thereby eliminating Twin City’s defense obligation.9
Following Twin City’s denial, the insureds brought an action for coverage in the U.S. District Court for the District of Colorado.10 After cross motions for summary judgment, the district court ruled for Twin City. At the core of the district court’s holding was its determination that the exclusion for prior knowledge in the warranty letter “was triggered by the allegations in the SEC’s amended complaint that, when read together, show that plaintiffs Rivelli and Johnson knew of the wrongful acts at Fischer that could rise to a claim under the Twin City Policy before May 1, 2002.”11
The Tenth Circuit’s Decision
The insureds appealed. Among other things, they contended that, in granting summary judgment, the district court: 1) unreasonably construed ambiguous language in the warranty letter; 2) erroneously “construed alternative and contradictory allegations in the SEC’s amended complaint as establishing that the claims were solely and entirely within the prior knowledge exclusion in the Warranty Letter”; 3) failed to acknowledge that the SEC’s claims could be satisfied by “mere negligence” that would not trigger the exclusion in the warranty letter; and 4) erroneously held that the “existence of any allegation of fact raising an inference of knowing wrongdoing establishes a prior knowledge exclusion as a matter of law, and eliminates a duty to defend in its entirety.”12
The Tenth Circuit rejected all of the insureds’ arguments and affirmed the district court’s ruling. The court of appeals did not agree that the language in the warranty letter was ambiguous.13 The court of appeals also found that the insureds had failed to identify any actual inconsistent, contradictory or frivolous allegations in the SEC’s complaint, and that “the district court correctly concluded that the SEC’s claims, when read together, compelled the conclusion that the SEC’s allegations were within the exclusion in the Warranty Letter.”14 In this regard, the court also discounted that the SEC’s claims might be satisfied by mere negligence or reckless indifference rather than actual knowledge, because that was not what the SEC actually had alleged.15 Finally, in response to the insureds’ point that Twin City had to show that they not only knew of facts related to acts that could give rise to a claim under the policy, but that “they appreciated that those facts could give rise to a claim under the policy,” the court, making a small leap of observation, found that: “It is untenable for plaintiffs to suggest that the allegations in the SEC’s amended complaint support a reasonable inference that each and every one of them could have failed to appreciate the potential for liability from the actions they are alleged to have taken prior to May 1, 2002.”16
A Cautionary Tale
Rivelli presents a cautionary tale for any prospective policyholder confronted with a request to sign a warranty letter. Critically, in the district court, Twin City actually acknowledged that the SEC’s claims would have triggered the coverage afforded by the top layer Twin City sold to Fischer but for the warranty letter.17 This stands to reason, because most policies containing actual “prior knowledge” exclusions also contain severability provisions that limit the application of the exclusion to those insureds who actually possessed the knowledge, which in this case would have preserved Twin City’s defense obligation as to any of the insureds who might not have had the requisite knowledge.18 Thus, far from merely restating the policy’s existing terms, the warranty letter in Rivelli provided the insurer with yet another basis upon which to avoid its defense cost coverage obligations.
In light of cases like Rivelli, a policyholder should, whenever possible, decline to sign a warranty letter. The insurer will already be protected to the extent necessary by the existing exclusions in the policy and through the policyholder’s provision of accurate information in the application. Except in the case of new market entrants, who may seek extra protection while they build up reserves, the only real reason for an insurer to request a warranty letter is to provide the insurer with yet an additional basis to limit otherwise favorable terms and conditions in the policy.
The holding in Rivelli II remains atypical, and should not be interpreted to create a new right for insurers to avoid their defense obligations based on the exclusionary effect of a warranty letter. Properly interpreted, Twin City’s warranty letter was activated only by definite knowledge of wrongful conduct giving rise to a claim of such severity that it could exceed the limits of the primary D&O coverage and the first layer of excess coverage.
The conclusions of the district court and the court of appeals that at least one of the Rivelli plaintiffs had such knowledge remain questionable, as very few insureds, even experienced business people, can actually predict the scope of potential litigation before it begins. In any event, the vast majority of securities-related complaints are not, in fact, written so narrowly that they prevent any likelihood of a potentially covered claim, and thus an insurer’s broad defense obligation typically should apply.