Warranty Precludes Coverage for SEC Action Under Excess Policy

The United States Court of Appeals for the Second Circuit, applying New York law, has held that a warranty executed before the inception of an excess directors and officers liability policy precluded coverage for a Securities and Exchange Commission (SEC) action because the insured knew of the SEC’s “escalating” investigation before the warranty was signed.  Patriarch Partners, LLC v. AXIS Ins. Co., 2018 WL 6431024 (2d Cir. Dec. 6, 2018).

The insured, an equity firm in the business of selling distressed loans, was the subject of an informal inquiry and an informal investigation by the SEC about certain loan obligations.  The SEC also interviewed two of the insured’s former executives and issued a formal order of investigation to the insured.  The insured’s founder, who also served as the insured’s sole officer and director, did not know of the formal order of investigation, but the insured’s outside counsel was aware of it.

After the SEC inquiries, the insured purchased a third layer of excess D&O coverage.  The insured also executed a warranty.  The insured represented that “neither the undersigned nor any other director or officer … is aware of any facts or circumstances that would reasonably be expected to result in a Claim[.]”  The warranty also stated, “[i]t is understood that the [policy] … does not provide coverage for Claims relating to facts or circumstances that, as of the date of this letter, [the insured] was aware of and would reasonably have expected to result in a Claim covered by such [policy]."

After the warranty was signed, the SEC subpoenaed the insured and later initiated a civil enforcement action.  The insured tendered the matter to the excess carrier, which denied coverage on the basis that the SEC investigation commenced before the policy’s inception was a “Claim” first made before the policy period.  The carrier also argued that the warranty relieved the carrier of its obligations under the policy.  In resulting coverage litigation, the district court held that the “Claim” was made before the policy incepted and that coverage was barred by the policy’s prior or pending claim exclusion.

On appeal, the Second Circuit affirmed on alternate grounds, holding that the warranty precluded coverage for the SEC proceeding.  The insured argued that the warranty required the knowledge of an officer or director, and the company’s sole director and officer was unaware of the SEC’s formal investigation before the warranty was executed.  The appeals court rejected this argument, determining that the warranty applied not only to officers and directors, but also to the insured company.  Based on agency principles, the court held that the insured’s outside counsel knew of the formal investigation before the warranty was executed and that knowledge was imputed to the insured.

The insured also argued that the warranty applied only to claims expected to reach the insurer’s excess layer.  The appeals court rejected the argument, concluding that, because the excess policy followed form to the primary policy, the warranty’s use of the term “Claim” meant a claim covered by the primary policy.

The appeals court held that, based on the SEC’s many contacts with the insured before the warranty was signed, the insured was aware of the “escalating severity and focus” of the SEC’s investigation and that the SEC “had become more – not less – insistent in its demands.”  The court noted the insured’s concession that the SEC’s interactions “were an indication that a Claim might be asserted against the [insured] in the future.”

Wiley Executive Summary

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