California Insurance - Directors and Officers Liability Insurance Does Not Cover a Corporation’s Contract Debts
August Entertainment, Inc. v. Philadelphia Indemnity Insurance Company, No. B184276 (Cal. Ct. App., January 8, 2007)
California’s Court of Appeal, Second District (Los Angeles), affirmed the dismissal of a bad faith lawsuit against a directors and officers liability insurer arising out of its refusal to defend a corporation and one of the
corporation’s officers in a breach of contract claim. According to the court, “to hold the insurer liable for the contract price would be tantamount making it a business partner of the corporation and the officer,
which is not the mutual intention of the insurer and insured under the policy.”
InternetStudios.com was sued for breach of contract in connection with a motion picture distribution agreement. The plaintiff later added one of the company’s officers as a defendant on the theory that the officer did
not indicate that he was signing the contract on behalf of the corporation and was therefore personally liable for the debt. The corporation tendered the suit to its D&O liability insurer under “Insuring Agreement
A,” which provided coverage to the company’s directors and officers for losses resulting from wrongful acts that the corporation had not paid on their behalf.
The insurer denied coverage to the corporation based on a policy exclusion for causes of action based on an express contract or agreement, and denied coverage to the officer because he was acting in an individual capacity and not as an officer of the insured. The corporation and its officer thereafter settled with the claimant, stipulating that the officer was acting in his corporate capacity,
agreeing to dismiss the corporation, agreeing to the entry of a $2 million judgment, and assigning the officer’s rights against the insurer to the claimant. When the claimant subsequently brought suit against the insurer,
the insurer’s demurrer ultimately was sustained without leave to amend based on the trial court’s view that the claimant was attempting to have the insurer pay for what essentially was a business debt of the insured’s.
The Court of Appeal agreed. The court initially observed that insofar as the corporation’s liability was concerned, the policy’s Insuring Agreement B expressly excluded coverage for contract obligations.
It next noted that under Insuring Agreement A the officer was insured only for conduct in his “official” capacity, which precluded coverage for two reasons: (1) an officer acting in an official capacity cannot be liable for breach of a corporate obligation, and (2) if the officer breached a contract in his individual capacity, then he was not acting in an insured capacity.
Following an extensive analysis of California law and relevant decisions of California federal courts and out-of-state decisions, the court held that the insurer was not liable for the underlying settlement or judgment. The
court recognized that to hold otherwise would make the insurer “a de facto party to a corporate contract and would require it to pay the full contract price (plus interest), letting the corporation off the hook.”
The court reasoned that neither the insurer nor the insured bargained for insurance benefits to cover the price of a business deal gone bad and that to saddle the insurer with that liability would not only increase its exposure without
compensation, but also would create a “moral hazard,” encouraging corporations to breach their contracts knowing that if they do, their D&O insurer will be liable for the debt.