The California Court of Appeal has held that a directors and officers policy did not cover a nonprofit organization’s directors for liability arising from the organization’s alleged default on municipal bonds. ( Medill v. Westport Ins. Corp. (2006) 143 Cal.App.4th 819)
Facts
Heritage Housing Development, Inc. (Heritage) was a nonprofit organization which raised money through municipal bonds in order to finance the acquisition and operation of healthcare facilities. After Heritage defaulted on the bond payments, the bondholders filed a securities class action against Heritage and several of its directors. The class alleged that Heritage, as private issuer of the bonds, was obligated to repay the principal, interest and any premium on the bonds. The class further alleged that Heritage and its directors mismanaged the bonds by running a “Ponzi” scheme whereby proceeds from subsequent bond offerings were used to mask cash shortfalls from prior offerings. The class asserted causes of action for violations of securities laws, breach of fiduciary duty, negligence and misrepresentation.
Heritage’s directors tendered defense of the action to Westport Insurance Corporation (Westport), which had issued a “Nonprofit Organization Liability Policy” to Heritage. Westport denied coverage for three reasons: (1) the policy’s definition of “loss” excluded coverage for claims arising out of breach of contract; (2) the policy excluded coverage for claims arising out of the issuance or endorsement of bonds; and (3) the policy excluded coverage for claims arising out of the failure to pay on financial instruments.
The directors sued Westport for breach of contract and bad faith arising from Westport’s refusal to defend in the underlying bond litigation. The trial court entered summary judgment in favor of Westport, and the directors appealed.
Holding
The Court of Appeal affirmed the summary judgment in favor of Westport. First, the court held that the underlying claim did not fall within the policy’s insuring agreement because there was no “loss.” The policy defined “loss” so as to exclude “damages arising out of breach of any contract, whether oral, written or implied….” The court held that the plaintiffs in the underlying class action sought to recover damages based on Heritage’s failure to perform its contractual obligation to repay the bonds. Thus, the underlying bond litigation “arose out of” a breach of contract, even though the underlying plaintiffs did not specifically allege breach of contract in their complaint.
Second, the court held that coverage was barred by the exclusion for “issuance or endorsement of bonds….” The court noted that Heritage as the obligor on the bond was deemed to be the issuer of these securities pursuant to Securities and Exchange Commission rules. Thus, Heritage “engaged in the excluded activity of issuing bonds or securities.”
Third, the court held that coverage was barred by the exclusion for any loss arising out of “the failure to honor or pay on any financial instrument.” According to the court, any ambiguity in the term “financial instrument” could be resolved by construing the phrase in the context of the policy as a whole. The court concluded that the underlying class action litigation clearly “arose out of Heritage’s failure to pay on a “financial instruments,” namely, the bonds.
Comment
The policy’s definition of “loss” excluded any damages arising from a breach of contract. In holding that definition of “loss” had not been satisfied, the court analyzed the conductunderlying the lawsuit against the directors rather than the legal theoriesattached to the conduct. In other words, irrespective of what labels were attached to the directors’ alleged wrongful acts, the directors’ alleged liability arose out of Heritage’s breach of contractual obligationsunder the bonds, for which coverage was not available.