Pleading Fraud and Bad Acts in D&O Claims Litigation

        An insurance policy covering directors and officers of a company can provide a valuable source of restitution for a bankruptcy estate and its creditors who have been wronged by actionable negligence and/or failures to act by corporate officers and directors. An informed plaintiff will read the applicable policy (prior to instituting suit if possible) closely, as such policies uniformly contain various exclusions to coverage.[1] When a claim against a director or officer (D&O) falls under a policy exclusion, the policy’s coverage might not apply to that claim. The insurer may issue a “reservation of rights” letter to its insured detailing those claims that the insurer has decided are not covered by the policy.

        One mainstay exclusion to D&O policy coverage is the “fraud exclusion.” This exclusion is often quite generally applied by insurers who seek to avoid coverage for claims involving a D&O’s fraud or personal enrichment.[2] On its face, a fraud exclusion will only apply “when there is an actual finding of dishonesty or fraud against a particular insured.”[3] The term “actual finding” has spawned litigation over coverage provisions.

       Generally, courts construe policy terms broadly “to protect the insured’s objectively reasonable expectations.”[4] Arch Insurance Co. involved shareholder’s claims in the Delaware Court of Chancery alleging fraudulent activity related to a privatization transaction. Conversely, courts interpret exclusionary clauses strictly and narrowly.[5]

       In re Dole Food Co.[6] typifies a court’s narrow interpretation of an exclusionary provision. The settlement order in Dole contained no findings with respect to the defendants’ fraud. The court held that the fraud exclusion provision did not apply because the court’s memorandum opinion finding fraud was not a “final and non-appealable” judgment (which was required by the terms of the policy). The only final and nonappealable order entered in the case was the settlement order, which did not address the court’s previous findings of fraud.[7]

       There is of course an inherent risk in pleading a defendant’s intentional, criminal, malicious or fraudulent acts. In pleading fraud and other bad acts, the plaintiff risks an ultimate finding that the policy does not cover the alleged acts. If the plaintiff prevails on fraud claims that are not covered, recovery must be sought apart from the policy directly from the defendants. Prior to pleading fraud, a prudent plaintiff should conduct some measure of due diligence on the financial status of the D&Os to determine whether defendants can satisfy a judgment on a non-covered claim.

       In framing its claims, the plaintiff should also consider whether fraud or misconduct allegations are so pervasive in the complaint that they in turn marginalize claims that are covered under the applicable policy. Plaintiffs need to make an initial evaluation of whether the gist of the complaint should sound in fraud or negligence. Although there is no bright line, and the facts leading to claims often lend support to both, the manner of pleading these claims will impact many facets of the case from discovery through settlement efforts and trial.

       What, then, is the efficacy of pleading fraud in the litigation? Are there occasions where pleading fraud in tandem with D&O claims make sense? Certain state law may require that all claims against defendants must be asserted in one forum.[8] Pleading fraud separately could result in consolidation of claims or causes of action in any event.[9] Aside from mandatory pleading requirements, convenience and cost, there may be other reasons to plead fraud despite an exclusionary provision.

       Companies frequently underestimate the coverage needs of their D&Os. Businesses settle for lean policies to save money. Indeed, it is not a rare occasion where the insurance policy limits in play are woefully short of the asserted damage claims of the plaintiff. The insurer may opt for settlement on covered claims, leaving the D&Os exposed to substantial liability on non-covered claims.

       An astute plaintiff might incorporate the specter of fraud (or other arguably excluded claims, such as avoidance claims) as a useful tool in bringing otherwise-recalcitrant D&Os to the table. After all, what financial incentive do the D&Os have to settle if they are fully covered?

       Plaintiffs should carefully review D&O policy coverage provisions for applicable exclusionary terms. Next, a prudent plaintiff will assess whether its damage claims may exceed policy coverage limits. If so, defendants’ financial strength must also be assessed. Plaintiffs should then weigh the benefits and detriments of pleading fraud and other bad acts in drafting pleadings. There is no “one size fits all” answer on the pleading of fraud in D&O complaints. However, rest assured exclusionary policy provisions may very well affect the outcome of your case and recovery.