Insurer Must Show that Reasonable Insured Would Have Concluded that Potential Claim Could Arise from Ongoing Investigation in Order to Apply Prior Knowledge Exclusion

The United States District Court for the Eastern District of Pennsylvania, applying Pennsylvania law, denied an insurer’s motion for summary judgment on the grounds that a genuine dispute of material fact existed as to whether the insured subjectively knew that an ongoing investigation could lead to a claim under its D&O insurance policy. Cantaloupe, Inc. v. AXIS Ins. Co., 2023 WL 8237245 (E.D. Pa. Nov. 28, 2023). The court did, however, grant the insurer’s motion for summary judgment on the insured’s bad faith claim.

An insured and two of its officers became the subject of numerous lawsuits and a regulatory action after it disclosed an internal investigation of accounting issues in an 8-K report. Two months prior to its 8-K filing the insured purchased a D&O insurance policy containing a prior knowledge exclusion, which barred coverage for any claim “based upon, arising out of or attributable to any fact, circumstance, or situation of which, as of the respective date indicated below [July 27, 2018] any Insured had knowledge and reasonably could give rise to a ‘Claim’ as that term is defined in the Followed Policy.” The insured tendered the various actions to its insurer. The insurer declined coverage based on email correspondence among the insured’s officers that occurred prior to July 27, 2018. Among other topics, certain officers voiced concern that revenues were not being accurately reported and expressed an unwillingness to certify financial statements. The insured sued for breach of contract, bad faith, and breach of the implied covenant of good faith and fair dealing. The insurer moved for summary judgment.

The court denied the insurer’s motion for summary judgment with respect to the breach of contract claim. The court rejected the insured’s contention that the prior knowledge exclusion was ambiguous and applied a two-part mixed subjective-objective test which required the insurer to show that i) the insured had knowledge of certain facts; and ii) a reasonable person in the insured’s position would have a basis to believe that a claim could arise from those facts. The court held that the first prong of the two-part test had been met because the insured had knowledge of facts that gave rise to the internal investigation. However, with respect to the second prong, the court ruled that there was a genuine dispute about the insured’s subjective knowledge at the time of accepting the D&O policy because its internal communications reflected uncertainty as to whether the revenue reporting issues were material.

Nevertheless, the court determined that the insurer did not act in bad faith because: i) it had a reasonable basis for denying the claim; and ii) because it did not knowingly or recklessly disregard a lack of reasonable basis in denying the claim.