10th Cir. Says 'Prior Knowledge' Lets D&O Insurer Off the Hook

A "prior knowledge" exclusion excuses an insurer from paying more to defend six Fischer Imaging Corp. officials even if some were ignorant of the underlying accounting fraud when the company bought the D&O policy, a federal appeals court in Denver has decided.

The 10th U.S. Circuit Court of Appeals rejected an appeal by half a dozen officers and directors of the medical imaging equipment maker who said a Colorado federal judge wrongly decided that Twin City Fire Insurance Co. need not advance another $2.5 million for legal bills in an underlying government enforcement action.

The case has been closely watched by insurance and corporate law practioners because it focuses on the issue of whether the guilty knowledge of some officers of a company at the time a policy was purchased was always enough to void defense cost coverage for all company officials.

The 10th Circuit said the key factor in determining that the prior-knowledge exclusion applied was that the Securities and Exchange Commission clearly alleged that most of the Fischer officers and directors had to know that viable charges could result from their accounting decisions.

The SEC brought the underlying enforcement action against former CEO Louis E. Rivelli, ex-CFO Rodney B. Johnson and four other corporate officers in 2003, alleging they had engaged in accounting fraud by recognizing revenue from sales that the company had not yet consummated.

Fischer settled the case in 2004, and the company's primary insurer, Federal Insurance Co., paid out defense costs and damages to the limit of its $7.5 million policy.

Once the primary insurance coverage was exhausted, Twin City, as the excess insurer, paid out $2.5 million in costs and expenses pursuant to its policy but refused to pay the second $2.5 million of its $5 million limit.

The six defendants in the SEC action filed this declaratory judgment suit against Twin City in the U.S. District Court for the District of Colorado, seeking a determination that the prior-knowledge exclusion did not apply and that Twin City was obligated to pay their defense costs in the SEC action.

U.S. District Judge Richard Matsch disagreed.

He ruled that a warranty letter that was attached to the policy excludes coverage of the remaining defense costs because Rivelli and Johnson, by virtue of their positions, had to be aware of at least some of the wrongs the SEC alleged.

Having found that Rivelli and Johnson had prior knowledge, the judge ruled that the exclusion applies to all six defendants.

On appeal, the officers and directors argued that the judge improperly went beyond the allegations of the complaint in the underlying action to determine that the prior-knowledge exclusion had been triggered.

They said they did not believe that their actions could lead to the SEC charges.

"Under the exclusionary language, it does not matter what the insureds believed, only what the SEC's amended complaint alleged they knew," the 10th Circuit panel wrote. "The exclusion requires only that the insureds had knowledge or information that could give rise to a claim under their insurance policy."

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Rivelli is represented by Charles Hecht of Hamil/Hecht LLC in Denver.Johnson is represented by Josiah Hatch of Ducker Montgomery Aronstein & Bess in Denver.Various other officers and directors are represented by David Zisser of Isaacson Rosenbaum P.C., Matthew Smith of Husch Blackwell Sanders LLP, John McDermott of Brownstein Hyatt Farber Schreck and Ross Pulkrabek of Starrs Mihm & Pulkrabek, all in Denver; David Bayless of Covington & Burling in San Francisco; and Martin Berliner and Steve McDonald of Berliner McDonald in Greenwood Village, Colo.Twin City is represented by Geoffrey Race, L. Michael Brooks Jr. and Adam O'Brien of Wells, Anderson & Race in Denver.