Financial services companies and their directors and officers are frequently the target of lawsuits alleging dishonest or fraudulent conduct.  Additionally, federal and state agencies increasingly target directors and officers for misconduct in the management of corporations and are devoting significant resources to investigating companies in the finance sector.

When properly structured, insurance provides one way to address the risk of such claims.  Although there is a common misconception that there can be no coverage for claims alleging intentional misconduct, insurance policies commonly provide such coverage.  For example, directors and officers liability insurance policies provide coverage for securities fraud and breach of fiduciary duty while employment practices liability policies provide coverage for claims alleging discrimination and wrongful termination.

A recent opinion by the United States Court of Appeals for the Second Circuit affirms this important point:  Nat’l Fire Ins. Co. v. E. Mishan & Sons, Inc. (“Emson”), 2016 U.S. App. LEXIS 10151 (2d Cir. June 1, 2016).  In the case, Emson faced two class action lawsuits alleging that it conspired with two other companies to deceptively trap customers into recurring credit card charges. The causes of action in the lawsuits included claims for fraud, violations of state consumer protection acts, violations of the Telephone Consumer Protection Act, and unjust enrichment.  After Emson sought coverage under its liability insurance policy, the trial court held that coverage was barred by a knowing violation exclusion because all of the allegations were caused by knowing violations of another’s rights.  On appeal, the Second Circuit reversed.  The court reasoned that it could not conclude “that the policy does not provide coverage, because the conduct triggering the knowing violation policy exclusion [was] not an element of each cause of action.”  The court noted that Emson could be liable even absent evidence “that it knowingly violated its customers’ right to privacy,” because “the actual conduct described [did] not rule out the possibility that Emson acted without intent to harm.”  The court, therefore, found that the insurer had an obligation to fully defend Emson in both lawsuits.

Given that they are frequently the target of suits alleging fraud, conspiracy, and other intentional wrongdoing, the case has broad implications for sophisticated companies engaged in the global capital markets.  The bottom line is that policyholders should not assume that a claim is not covered simply because it alleges intentional misconduct.  See also J.P. Morgan Sec. Inc. v. Vigilant Ins. Co., 126 A.D.3d 76, 82, 2 N.Y.S.3d 415, 419 (N.Y. App. Div. 2015) (payments by Bear Sterns to settle claim with SEC were not excluded by dishonest acts exclusion since settlement did not constitute adjudication of wrongdoing within meaning of exclusion).

Policyholders, however, are well-advised to make sure that their liability insurance policies are written to maximize the likelihood that such claims will be covered.  As highlighted by the Emson decision, exclusions that purport to bar coverage for dishonest or fraudulent conduct are one common obstacle to coverage for claims against financial institutions and financial services companies.  See, e.g., Dupree v. Scottsdale Ins. Co., 129 A.D.3d 586, 587, 12 N.Y.S.3d 62 (N.Y. App. Div.) (claims against chief investment officer alleging conspiracy to commit bank fraud, bank fraud, and making false statements were not covered following criminal conviction); see also Millennium Partners, L.P. v. Select Ins. Co., 24 Misc. 3d 212, 217, 882 N.Y.S.2d 849, 854 (Sup. Ct.) (funds paid by hedge fund to settle claim constituted disgorgement of improperly obtained funds and were not insurable).

To minimize the scope and effect of these types of exclusions, policyholders should carefully consider the way their insurance policies are drafted and address, among other things, the following three issues:

  • Make sure that the language of any dishonesty exclusion specifically identifies the conduct that will be excluded.  The exclusion should not bar coverage for “reckless” or “criminal” conduct, as that could limit coverage for a variety of common claims.
  • The application of any dishonesty exclusion should be tied to a final adjudication in the underlying case.  Including this language will help preserve coverage for defense costs and possibly settlements, and will help avoid a scenario where you are re-litigating the merits of the underlying claim in a subsequent coverage suit.
  • Include a severability clause in any dishonesty exclusion so that the exclusion applies only to the bad actor.  This way the exclusion does not bar coverage for any innocent insureds.