Known Circumstances Exclusion:  Excluding Coverage on What You Already Know

11.06.2013

A common, but often overlooked, D & O insurance policy term is that of the “Known Circumstances Exclusion.”  This exclusion is included in order to exclude from coverage potential liabilities known by the company and its executives.

Last month the federal First Circuit Court of Appeals had occasion to rule on the Known Circumstances Exclusion in Clark School for Creative Learning, Inc. v. Philadelphia Indem. Ins. Co., 2013 WL 5737339 (1st Cir. 2013).  The Clark School, a non-profit, independent K-12 school in Massachusetts was struggling financially.  It had suffered a series of significant financial shortfalls in 2006 and 2007, and its liabilities exceeded its assets by hundreds-of-thousands of dollars.  In May 2008, Marcia and Joseph Valenti, parents of three Clark School students donated $500,000 to the School, which was disclosed on the School’s financial statements.

One year later, in May 2009, the Valentis filed suit against the School and its director, Jeffrey Clark (“Clark”), in state court asserting that the School did not follow through on several promises made in soliciting the donation.  At that time, the School and Clark were insured by Philadelphia Indemnity Insurance Company under a Non-Profit Organization Directors and Officers Flexi Plus Five Policy.  Under the Policy, Philadelphia was to indemnify the School and Clark for any “Loss,” including legal defense cost and damages for a “D & O Wrongful Act” including any “act, error, misstatement, misleading statement, neglect, breach of duty or personal and advertising injury” committed by the School or Clark.

The Policy also included a “Known Circumstances Revealed in Financial Statement Exclusion,” that specifically provided:

[T]he Underwriter shall not be liable to make any payment for Loss in connection with any Claim made against the Insured based upon, arising out of, directly or indirectly resulting from or in consequence of, or in any way involving any matter, fact, or circumstance disclosed in connection with Note 8 of the Financial Statement . . . submitted on behalf of the Insured.

Note 8 was titled “Insufficient Net Assets.”  It discussed the School’s financial difficulties at length and also specifically referenced the Valentis’ gift stating:

Subsequent to the date of the accompanying financial statement, in May of 2008 the School was a recipient of a major gift totaling $500,000 (see Note 7) [(Note 7 discussed, in detail, the Valenti gift)] . . .

The School notified Philadelphia of the Valentis’ suit.  The insurer denied coverage under the policy asserting that the costs associated with the suit were losses excluded from coverage from the Known Circumstances Exclusion.  The School continued the litigation at its own expense and ultimately settled with the Valentis, agreeing to return a portion of the gift. 

In March 2012, the School brought suit in federal district court seeking indemnification from Philadelphia for the costs of defending and settling the Valenti litigation.  The district court rejected the School’s contentions, noting that the Known Circumstances Exclusion expressly referenced Note 8 of the financial statement, which specifically addressed the Valenti gift.  Moreover the suit against Philadelphia was specifically to recoup the loss and defense costs which were incurred as a result of the Valenti litigation – which in turn was solely related to the Valenti gift.  Therefore the plain language of the Known Circumstances Exclusion excludes from coverage the losses from the suit brought by the Valentis about their gift.

The School appealed to the First Circuit Court of Appeals asserting various claims including: (1) the language of the Known Circumstances Exclusion shows the parties did not intend for the exclusion to apply to the Valentis’ gift; and (2) the plain language of the policy must control and give way to the School’s reasonable expectation of coverage.  The First Circuit disagreed with the School and affirmed the district court’s opinion, noting the policy language is plainly not limited to the losses caused by the financial difficulties as it explicitly references the Valentis’ gift.

Ultimately, both the district court and the appellate court’s opinions were based on the plain language of the Policy.  In essence, the School could not hope to recover from its insurer related to the Valentis’ gift, where the Known Circumstances Exclusion specifically and expressly excluded from coverage liabilities relating to that gift.

Frank Cragle is a trial lawyer and a member of Hirschler Fleischer’s Insurance Recovery Team. He handles a variety of commercial business disputes, including insurance recovery and policyholder claims. Frank also devotes a substantial portion of his time to business tort litigation and intellectual property claims. For more information, contact Frank at 804.771.9515 or fcragle@hf-law.com.