Can insurers rely on fraud exclusions to deny advancing deference costs?

D&O Insurance: to what extent can Insurers rely on the fraud exclusion to deny having to advance defence costs? This issue was recently considered by the High Court of Australia in Daniel Wilkie - v – Gordian Runoff Limited (formerly known as GIO Insurance Limited) & Anor

In the recent case of Daniel Wilkie v Gordian Runoff Limited [2005] HCA 17 the High Court of Australia virtually slammed the door shut on D&O insurers’ ability to rely on the fraud exclusion to deny a claim for advancement of defence.

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It is usually the case that a D&O policy specifically excludes coverage for any loss arising from fraud or dishonest act or omission by an insured director or officer. The exclusion only becomes operative, however, if the fraud or dishonest act has been established at judgment or admission of the insured. Until either of these provisos have been satisfied, therefore, the claim is covered.

A standard D&O policy will also provide that Insurers have to advance defence costs to an Insured director or officer prior to the determination of any covered claim against the insured. Indeed the ability to receive payment of defence costs in advance of a claim against the director or officer being determined is the main selling point for D&O insurance.

The interplay of the fraud exclusion and the provision for advancing defence costs in a D&O policy is an issue that has long exercised D&O insurers. If, for example, insurers advance defence costs to an insured accused of fraud, and then subsequently the insured is determined by judgment to have been fraudulent, technically the insured’s claim will be excluded at that point and insurers will be entitled to recover any defence costs they have advanced. The problem is, however, that by then, the fraudulent director is no longer a healthy credit risk – especially if he faces prison – and the reality is that insurers are unlikely ever to see their money again.

In light of this, there is always tension between D&O insurers and their insureds when an insured seeks advancement of defence costs under a D&O Policy to defend a claim in which he or she is accused of fraud or dishonesty. When this happens the question which D&O insurers perpetually ask themselves is: "to what extent can we avoid having to advance such costs by relying on the fraud exclusion?" This question was recently considered by the High Court of Australia in Daniel Wilkie v Gordian Runoff Limited.

The case concerned the operation of a D&O policy which covered the acts and omissions of the Directors and Officers of FAI Insurance Limited ("the Policy"). As is usually the case, the Policy excluded coverage for any loss arising any claim based upon any dishonest, fraudulent, criminal or malicious act or omission which had in fact occurred. The exclusion (Exclusion 7) specifically stated that the words ‘in fact’ meant that the dishonest, fraudulent, criminal or malicious act or omission had either to be admitted by the insured or subsequently established to have occurred following adjudication by any court, tribunal or arbitrator.

The Policy also provided, by Extension 9, that Insurers would be liable to advance defence costs under the Policy, but the advancement of such costs was subject to two provisos first having been satisfied namely that:

1. Insurers had not denied indemnity for the Claim; and
2. the written consent of Insurers had been obtained prior to the Insured incurring such Defence Costs (such consent not to be unreasonably withheld).

Mr Wilkie was an insured director under the Policy. He became the target of criminal proceedings instituted by the Australian Securities and Investments Commission ("ASIC") alleging, inter alia, that he had provided FAI’s auditors with materially misleading information, had failed to act honestly and had discharged his duties of office with the intention of deceiving the auditors. Mr Wilkie notified a claim under the Policy and sought an advancement of defence costs from insurers to assist him in defending ASIC’s prosecution.

Insurers, having considered ASIC’s brief of evidence against Mr Wilkie, denied his claim for indemnity under the Policy on the basis that there was sufficient evidence of fraud to ensure that Exclusion 7 had been satisfied. Having denied the claim, therefore, insurers relied on proviso i) (quoted above) in Extension 9 (the advancement of defence costs extension) to deny Mr Wilkie’s claim for an advancement of defence costs.

In a surprising result, the Supreme Court of New South Wales initially decided the case in favour of insurers, considering that as insurers had denied indemnity they were not liable to advance defence costs, as stated in proviso i) in Extension 9.

However, the High Court of Australia overturned the decision. It considered that Exclusion 7 made it clear that coverage for a claim involving fraud or dishonesty was only excluded if either the insured had admitted the fraud or dishonesty or if the fraud or dishonesty had been established by judgment. Neither was the case here and as such, insurers could not rely on Exclusion 7 to deny the insured’s primary right to indemnity under the Policy. This meant that insurers’ purported denial did not satisfy proviso i) in Extension 9, as the grounds for denial were in themselves insufficient to exclude the Mr Wilkie’s primary right to indemnity (Exclusion 7 not being applicable). Accordingly, insurers were obliged to advance defence costs.

The High Court noted that the way in which insurers were seeking to construe the Policy effectively meant "that in a real and practical sense [Insurers] would become the final arbiters of the extent of their obligations because their insured will frequently lack the means to defend themselves adequately against the charges levelled against them unless they are put in funds to do so. It would not have been a difficult matter for [Insurers] to have insisted upon a policy that put beyond doubt their right to postpone payment of defence costs until the outcome is known had they so wished."

Strictly speaking, the case is confined to its own facts and in particular to the specific wording of the Policy under consideration. That said, when the initial decision from the Supreme Court of New South Wales was delivered, it was scrutinised by many D&O insurers to see if it provided a means by which they could avoid having to advance defence costs to insureds accused of fraud or dishonesty.

It is submitted, that the High Court of Australia has now restored some sanity to this important issue. The fact remains that one of the most marketable aspects of D&O insurance is the access it provides insureds to receive defence costs in advance of a case being resolved. Any inhibition placed on an insured’s ability to access such defence costs, significantly reduces the value of the coverage provided.

As stated, the High Court of Australia did note that it was open to insurers to provide themselves with a specific discretion in their policies to postpone the insured’s right to advancement of defence costs until the outcome of a claim was known and the insertion of such clauses in the past has been indicative of harder markets. In the current soft cycle in Hong Kong, however, brokers have successfully resisted attempts to include any discretion on the part of insurers to advance defence costs in D&O policies. The result is that if an insured director or officer is accused of fraud or dishonesty and wants an advancement of Defence Costs, then insurers will have little choice but to accede. Insurers will be better placed trying to control the level of costs they advance by a) scrutinising the extent to which the allegations against the insured fall within the insuring clause in the first place; and b) keeping a tight reign on costs incurred by the appointed lawyers, rather than in trying to deny provision of defence costs altogether based upon the fraud exclusion.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 11/05/2005.