Why it matters: A New York federal court affirmed that in order for an insurer to avoid its coverage obligations pursuant to an exclusion in the policy, it must demonstrate that the allegations of the underlying complaint cast the pleadings "wholly within that exclusion." The court found that allegations that an employee trust was underfunded did not fall "wholly within" a policy exclusion for "mishandling funds," and thus ordered the insurer to provide a defense to the trustees facing two separate lawsuits. In these lawsuits, the trustees of an employee trust were sued for allegedly violating their duties and leaving the trust underfunded by millions of dollars. The trustees tendered defense of the suits to their directors and officers' insurer, but the insurer refused, relying on a policy exclusion for the "mishandling of funds." In a coverage lawsuit filed by the trustees in New York federal court, the judge sided with the trustees. Not all of the claims asserted against the trustees related to the mishandling of funds, the court said, with other allegations that the trustees failed to take corrective actions and properly administer the trust. The insurer was obligated to provide a defense because some of the allegations fell outside of the exclusion, the judge ordered.

Detailed discussion: Executive Risk Indemnity, Inc., issued a Directors and Officers (D&O) policy to the New York State Association of Health Care Providers for a period running January 1, 2011, to January 1, 2012. The policy provided coverage for "any past, present or future director, officer [or] trustee" of the organizations and the Health Care Providers Self-Insurance Trust.

The policy featured certain exclusions, including one for claims that are "based upon, arising out of, directly or indirectly resulting from, in consequence of, or in any way involving … any commingling or mishandling of funds."

On July 8, 2011, the New York State Workers' Compensation Board sued the trustees of the Trust, alleging that the defendants acted improperly in the administration and maintenance of the trust, failing to satisfy their duties as trustees and resulting in the trust being underfunded by several million dollars. A second lawsuit with similar allegations followed.

The trustees notified Executive Risk and requested a defense for both lawsuits. Citing the exclusion for "mishandling funds," the insurer disclaimed coverage. The trustees filed suit against Executive Risk, arguing that the allegations against them did not clearly and entirely fall within the policy's exclusion.

Ruling on the dueling motions for summary judgment, the court found for the trustees. Coverage is required whenever the allegations of the complaint suggest "a reasonable possibility of coverage," U.S. District Court Judge Gary L. Sharpe wrote.

"Although ERII argues that the gravamen of the underlying actions stems from plaintiffs'—defendants in the state court actions—'mishandling of funds,' such that defense for the underlying actions would fall within the policy's exclusion clause, that argument is unavailing," the court said. "ERII fails to acknowledge the well-settled principle that, in order to rely on an exclusionary clause as a basis to disclaim coverage, an insurer must demonstrate that the 'allegations of the [underlying] complaint[s] cast the pleadings wholly within that exclusion.' "

As set forth by the trustees, "many of the allegations in the underlying complaints would appear to be plainly encompassed by the policy," the judge said.

Allegations included the failure "to take sufficient or timely corrective actions to establish the financial viability of the Trust," the failure "to properly administer the affairs of the Trust," actions by the trustees that "caused the Trust to enter into contracts and agreements that were detrimental to the Trust," and that the trustees neglected to "properly and timely inform the members of the Trust of the true financial status of the Trust." The complaints also asserted the trustees breached their fiduciary duties and failed to ensure that the trust was at all times properly capitalized.

"These allegations fall squarely within the policy's terms requiring coverage for 'Wrongful Act[s],' " Judge Sharpe wrote. "[W]hile some of the allegations and causes of action in the underlying actions may potentially constitute 'mishandling of funds,' it is clear that other allegations and causes of action plainly fall within the purview of the policy's coverage of liability for 'wrongful acts.' Accordingly, given that certain allegations are encompassed by the policy, '[it is immaterial] that the [underlying] complaint[s] against [plaintiffs] assert[] additional claims which fall outside the policy's general coverage or within exclusionary provisions,' and ERII is therefore obligated to provide coverage."

To read the decision in Balaban-Krauss v. Executive Risk Indemnity, click here.