The United States District Court for the Southern District of Ohio, applying Ohio law, has held that a dishonesty exclusion barred coverage under primary and excess directors and officers (D&O) policies for the Wrongful Acts of the principals of a bankrupt company, all of whom were criminally convicted of securities fraud and related crimes.  The Unencumbered Assets Trust v. Great American Insurance Co., et. al., 2011 WL 4348128 (S.D. Ohio Sept. 16, 2011).  The court also refused to declare an excess policy void ab initio because a genuine issue of material fact existed as to whether the excess insurer waived its right to rescind the policy when it knew about the misstatements in the policy application at the time it accepted payment for tail coverage.

The bankrupt company at issue was in the business of purchasing accounts receivable at a discount from healthcare providers.  The company’s principals raised capital by issuing notes to investors that the principals represented were secured by healthcare receivables.  Many of the accounts receivable that the bankrupt company “purchased” were in fact worthless or nonexistent, and much of the capital raised went to companies in which the principals had undisclosed ownership interests.  As characterized by the court, the principals engineered a multi-billion dollar fraudulent scheme and went to “extraordinary lengths to conceal what [they] were actually doing.”  As a result, the principals were all convicted of securities fraud and other crimes.

The primary and excess D&O policies issued to the bankrupt company contained a dishonesty exclusion that barred coverage for claims where the insured commits a fraudulent or dishonest act, and separately provided that an untrue statement or misrepresentation in the insurance application would render the policy void ab initio with respect to those who knew the statements were untrue.  The excess insurer argued that the convictions of the principals triggered the dishonesty exclusion and, additionally, that the fraud committed in the procurement of the policy rendered it void ab initio.  The principals argued that the dishonesty exclusion did not apply because not all of their convictions were “final.”  The court rejected this argument, granting summary judgment for the insurer on this issue and holding that exhaustion of appellate review was not required to trigger the dishonesty exclusion.

The trust representing the bankrupt company’s creditors contended that, to the extent the dishonesty exclusion was triggered, the adverse interest exception protected the creditors’ right to coverage, as the principals’ fraud should not be imputed to the entity because they were acting on their own behalf.  The court rejected this argument and held that under the sole actor rule, the principals’ fraudulent acts were imputed to the company and its subsidiaries because those entities were dominated and controlled by the principals, thus excluding coverage for the company and its subsidiaries under the policy’s dishonesty exclusion.

With respect to the insurer’s rescission argument, the trust argued that no provision in the policy permitted the insurer to rescind the policy as void ab initio and that the insurer waived the right to rescind when it accepted the premium payment for tail coverage.  The court found that the policy was capable of being declared void ab initio because: (i) the misstatements of material facts in the insurance application were warranties, rather than representations; (ii) the insurance application was incorporated into the policy; (iii) the terms of the policy clearly and unambiguously provided that a misstatement by the insured would render the policy void ab initio; and (iv) a clause in the application modified the policy’s severability language and expressly provided that the principal’s knowledge of material facts when he signed the application form would be imputed to other insureds for purposes of determining the validity of the policy.  However, the court refused to declare the policy void ab initio because a genuine issue of material fact existed as to whether the insurer knew about the financial misstatements in the application at the time the insurer accepted the premium for tail coverage, and therefore waived its right to rescind the policy.