The Fourth Circuit has affirmed a Virginia district court’s decision, finding the conviction of an insured in an underlying criminal case ended an insurer’s obligation to pay defense costs pursuant to a D&O policy. Farkas v. Nat’l Union Fire Ins. Co. of Pittsburgh, Pa, No. 12-1481 (4th Cir. Apr. 11, 2013) (unpublished).

National Union provided D&O coverage to TBW, a mortgage corporation. The policy required the insurer to

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advance defense costs of a covered claim prior to the claim’s final disposition. The policy excluded coverage for claims made against the insured: [4(a)] arising out, based upon, or attributable to the gaining in fact of any profit or advantage to which Insured was not legally entitled; [and] …. [4(c)] arising out of, based upon, or attributable to the committing in fact of any criminal, fraudulent or dishonest act, or any willful violation of any statute, rule or law.”  Farkas was indicted for bank, wire and securities fraud. When TBW entered bankruptcy, the bankruptcy court approved National Union expending up to $3 million in defense costs – $1 million for Farkas, and $1 million each for two other officers.

Several days into Farkas’ criminal trial, National Union notified Farkas’ counsel that defense invoices submitted exceeded $1 million and National Union would not advance any more funds without approval of the bankruptcy court. Shortly thereafter, while the parties awaited a ruling from the bankruptcy court, a jury found Farkas guilty on 16 counts of fraud and conspiracy. National Union informed Farkas the jury’s verdict triggered the “in fact” element of the Exclusions 4(a) and 4(c) and it would no longer fund the defense. Farkas appealed the criminal conviction and filed a declaratory action against National Union.

The “in fact” exclusion: Farkas argued, among other things, the “in fact” language was ambiguous, and he was entitled to coverage while he appealed the conviction. The court rejected the argument, opining that the majority of cases addressing an exclusion triggered by an “in fact” finding support the view that the exclusion takes effect with some pertinent factual finding that an insured’s behavior fell within an exclusion. The court noted that although several courts have concluded that an “in fact” finding requires a final adjudication, none of the cases defined a final adjudication as an appeal.

Farkas also argued National Union was prevented from unilaterally deciding the exclusion was triggered by the conviction, arguing National Union should have been required to file a declaratory judgment action. The court rejected the argument, holding that either the conviction or a declaratory judgment was appropriate to trigger the exclusions.

Costs incurred before jury verdict: At the time of conviction, National Union had expended approximately $928,000, but had received invoices exceeding $1 million. Farkas argued National Union should be required to pay at least the additional, approximate $72,000 of those expenses incurred by the time of the conviction. The court rejected the argument on the ground that the conviction meant Farkas was never entitled to the coverage. In so finding, the court considered the fact that National Union had not “dragged its feet” before advancing defense costs or engaged in other dubious behavior.

Recoupment: The policy provided that defense costs advanced to the insured must be repaid if the insured was not entitled to the coverage. Farkas objected to such repayment on the grounds that the policy did not provide for joint and several liability of Farkas and TBW, and National Union had filed a claim against TBW in bankruptcy court. The court granted National Union summary judgment, holding National Union was not prohibited from filing a claim against TBW and also seeking recoupment from Farkas; it could only collect once.

Stay: Farkas also requested that the court, if it determined the verdict triggered the exclusions, stay the decision pending a review of the conviction. For Farkas to obtain a stay he was required to establish: (1) he was likely to succeed on the merits;, (2) he was likely to suffer irreparable harm in the absence of preliminary relief; (3) the balance of equity tipped in his favor; and (4) an injunction was in the public interest. The court concluded he satisfied none of those elements and declined to issue a stay.