A Common Law Approach to D&O Insurance “In Fact” Exclusion Disputes

Directors’ and Officers’ (D&O) liability insurance policies are a staple of the modern corporate world. Held by virtually all major organizations, these policies protect their beneficiaries from losses suffered in connection with directors’ and officers’ performance of their duties. The policies fund the defense of lawsuits and reimburse policyholders for settlements and adverse judgments.

Like other types of liability insurance, D&O policies do not provide universal coverage. One common exclusion—the personal profit exclusion—prevents coverage of losses caused by the insured’s wrongful conduct from which he inappropriately profited. For example, this provision would preclude coverage of a judgment against an executive for accepting kickbacks from a corporation’s suppliers. These exclusions shield insurance carriers from the significant moral hazard that would result if executives could be reimbursed for damages that arise from their illegal profiteering. They also protect organizations, as they ensure that D&O policies do not create perverse incentives for executives to engage in wrongdoing. For the executives, of course, the exclusions matter because they may strip the executives of the benefits of coverage.

Personal profit exclusions generally state that they apply when executives have “in fact” profited from their conduct. This “in fact” formulation has caused confusion both about when the insurer can invoke the exclusion and about the quantum of proof necessary to establish that the exclusion applies. To understand the problem, imagine a situation in which an organization’s directors misappropriated company information and used it to start their own firm. The shareholders of the original organization bring suit, alleging in their complaint that the board members breached their duty of loyalty by usurping a corporate opportunity. Imagine further that these board members make a claim under their D&O policy. The insurance carrier, naturally, seeks to prevent coverage—to avoid paying for the board members’ defense and for any ultimate judgment—by invoking the policy’s personal profit exclusion. What should the carrier need to establish to show that the board members profited from their conduct? Are allegations of personal profit in the complaint against the insured sufficient? Or should there be a judicial determination that the executives reaped an improper personal profit? Should the carrier be able to produce its own evidence that the executives profited? If so, when should the carrier be allowed to make this showing? Can it deny the executives coverage before the underlying case is litigated? Or must it wait until that case has concluded?