First Circuit Holds Prior Knowledge Exclusion Applicable

In its recent decision in Clark School for Creative Learning, Inc. v. Philadelphia Indemnity Ins. Co., 2013 U.S. App. LEXIS 21568 (1^st Cir. Oct. 23, 2013), the United States Court of Appeals for the First Circuit, applying Massachusetts law, had occasion to consider the application of a known circumstances exclusion in a directors and officers policy.

Philadelphia Indemnity Insurance Company (“PIIC”) insured the Clark School (the “School”) under a claims made and reported D&O policy issued for the period July 1, 2008 to July 1, 2009.  The Clark School is a non-profit, private school located in Danvers, Massachusetts. In May 2008, as a direct result of the School’s precarious financial difficulties, the School received a $500,000 donation from a family of three enrolled students, subject to the conditions that the family would receive a security interest in the land on which the School is located and that the funds would be used to construct a new high school.  The donation was reflected in a financial statement published prior to the inception date of the PIIC policy.  In May 2009, the family sued the School and its director for failing to satisfy these conditions.  It was alleged that the School’s director caused the School to pay $175,000 of the donated funds to his own mother and sister “purportedly for the repayment of loans.”

PIIC’s policy contained a manuscript exclusion titled Known Circumstances Revealed In Financial Statement Exclusion, which stated:

[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 of the financial statement referred to in this exclusion specifically described the School’s financial difficulties and the $500,000 donation:

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). The donation is unrestricted and will be used to support the School's general operations as management's plans for the School's future are implemented and allowed time to succeed. Management feels that its plans and the subsequent major gift will enable the School to operate as a going concern.

Note 7, referenced in this paragraph, made further reference to the $500,000 donation.

PIIC disclaimed coverage to the School for the underlying suit on the basis of this exclusion, and in the ensuing coverage litigation, the United States District Court for the District of Massachusetts ruled in PIIC’s favor.  On appeal, the School argued that the exclusion should be read to relate solely to the School’s financial difficulties and not to and claims involving the donation.  The School also argued that various rules of contract construction, including the concept of reasonable expectations, required a more limited reading than applied by the lower court. 

The First Circuit disagreed with the School’s arguments regarding the exclusion, observing that it was plain and unambiguous on its face.  With respect to the School’s argument that the exclusion should be limited to financial difficulties alone, the court concluded that the reference in Note 8 to $500,000 donation, as well as to Note 7, which also described the donation, indicated that the exclusion could not be read as being limited to losses resulting from the School’s financial difficulties.  The court also rejected the School’s argument that the phrase “in any way involving” as used in the exclusion must include a “causal element,” and that the underlying loss was not caused by the donation.  The court the phrase “in any way involving” to represent “a mop-up clause intended to exclude anything not already excluded by” the other terms of the exclusion.  Regardless, the court held that even if a causation element was required, this was more than satisfied as the underlying loss was caused by the School’s misrepresentations concerning the donations.   Finally, the court rejected the School’s reasonable expectations argument on the basis that the exclusion was not ambiguous and that there could be no reasonable uncertainty as to what its scope.