The United States District Court for the District of Colorado recently held that a warranty letter's prior knowledge exclusion barred coverage for defense costs incurred by the insured directors and officers in an enforcement action initiated by the SEC. A copy of the decision can be found here. Rivelli v. Twin City Fire Insurance Company, C.A. No. 08-01225-RPM (November 21, 2008).

The policy at issue was an excess D&O policy providing a $5 million limit of liability excess of the primary D&O limit. The insurer reimbursed the first $2.5 million of defense costs submitted under its excess policy. The insurer refused to reimburse an additional $2.5 million in defense costs sought by the insureds because reimbursement of the further amounts was barred by a prior knowledge exclusion contained in an April 30, 2002 warranty letter executed by the insured's CEO prior to the renewal of the policy. That is, in exchange for an additional $2.5 million in limits on the renewal policy, the insured's CEO had warranted that he did not have knowledge of an act, error, omission, fact or circumstance that might give rise to a claim. Where such information existed, the warranty letter provided that any Claim arising therefrom would be excluded from the purchased additional coverage.

Both parties filed motions for summary judgment on the issued of the applicability of the prior knowledge exclusion. After reviewing the allegations of the SEC complaint, the court held that the exclusion barred coverage for the additional $2.5 million in limits because the CEO knew of wrongful activities that could give rise to a Claim under the policy prior to the execution of the warranty letter. In particular, the court rejected the insureds' argument that the CEO's knowledge of the contingent nature of the particular sales transactions at issue and the timing of the revenue recognition were not sufficient to trigger the prior knowledge exclusion because the CEO could have failed to appreciate the wrongful nature of such acts. Rather, the court found that the CEO or CFO of a public company could not fail to appreciate the liability created by the wrongful activities alleged in the SEC's complaint.

In light of the fact that the warranty letter did not contain a severability provision, the court held that the insurer was justified in denying coverage to all insureds for the increased limits.

For a copy of the decision, please click here.