Today, many lawsuits against directors and officers contain allegations of fraud, especially in securities cases. This is partially the result of passage of the Private Securities Litigation Reform Act in 1995, which was aimed at encouraging meritorious lawsuits while discouraging frivolous suits. One of the results of the Act was to increase the pleading requirements as respects fraud and dishonesty.

Most D&O insurance policies contain some form of dishonesty and fraud exclusion designed to preclude coverage for claims based on or arising out of dishonest, fraudulent, and criminal acts committed by individual insureds. An example of a broadly worded form of the exclusion, taken from an old D&O policy, follows.

The insurer shall not be liable to make any payment for loss arising from, by reason of or in connection with:

(K) the fraudulent, dishonest or criminal acts of the assureds;

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This exclusion may appear reasonable because these actions are not normally insurable as a matter of public policy, nor are they generally indemnifiable by state law. A potential problem with such language, however, is that sometimes there is no specific exception to the exclusion that would allow coverage for defense when dishonesty is alleged but not proven.

After passage of the reform act in 1995, many insurers began introducing dishonesty and fraud exclusions that were amended so that the exclusions would only apply when a final judgment establishes that such fraudulent, dishonest, or criminal acts did in fact occur. Two examples of this language follow.

The Insurer shall not be liable to make any payment for Loss in connection with a Claim made against any Insured:

B. based upon, arising out of, directly or indirectly resulting from or in consequence of, or in any way involving the committing in fact of any criminal or deliberate fraudulent act.

Admiral DO 1200

The Insurer shall not be liable for Loss on account of any Claim:

C. based upon, arising out of or attributable to:

2. Any willful violation of any statute or regulation or any deliberately criminal or fraudulent act, error or omission by the Insured:

If established by a final and non-appealable adjudication adverse to such Insured in the underlying action.

Axis Insurance Company, MCL 0001

Language requiring an establishment “n fact” or by “judgment or other final adjudication” as shown in these examples means that the exclusion applies only when directors and officers have been found by a court to be guilty of dishonesty or other excluded acts. Such a requirement is desirable from the insured's standpoint, especially considering that a large percentage of claims result in voluntary settlement without final adjudication or an admission of wrongdoing.

When a defendant insured enters into a voluntary settlement that requires the insurer's consent, the settlement effectively prevents an adjudication on the issue of dishonesty, which in turn prevents the exclusion from applying. Once the insurer consents to a settlement, the courts generally have barred any further litigation by the insurer to establish the insured's dishonesty.

Although some policies allow coverage for dishonest, fraudulent, or criminal acts if a judgment or other final adjudication fails to establish that such acts actually occurred, it is not always clear when dishonesty “in fact” occurs. The term in fact may imply less of a threshold for proof than adjudication and, therefore, language requiring a final adjudication is preferable. Use of the term in fact may not bar the insurer from separately litigating the issue of an individual insured's dishonesty.

There is great variety in the wording of dishonesty exclusions. As illustrated in the following example, many insurers combine fraudulent, dishonest, and criminal acts in a single exclusion. Others break these offenses into separate, individual exclusions. Even when a unitary exclusion is used and is subject to an exception, the exception may extend only to one act, such as dishonesty, as in the following example taken from an old policy form.