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HOME INS. CO. v. SPECTRUM INFORMATION TECHS.

July 15, 1996

THE HOME INSURANCE COMPANY OF ILLINOIS (NEW HAMPSHIRE), Plaintiff, against SPECTRUM INFORMATION TECHNOLOGIES, INC., PETER T. CASERTA, DANA VERRILL, A. WERNER PLEUS, JOHN RULE, ALBERT PANICO, JOHN SCULLEY, SALVATORE MARINO, ANDREW MIGLIORINI, JOHN P. BOHRMAN, A.C. DALTON, JOSEPH H. ALLEN, EDWARD N. MASKALY, CHRISTOPHER T. McGOWAN, RONALD S. GLASSNER, BERNARD H. GUDVI, PHILLIP E. JENNINGS, KAILAS J. RAO, and JOHN DOES 1-100, Defendants.


The opinion of the court was delivered by: BLOCK

 BLOCK, District Judge:

 Plaintiffs Home Insurance Company of Illinois ("Home") and Aetna Casualty and Surety Company ("Aetna") bring this action for declaratory relief and rescission pursuant to 28 U.S.C. §§ 157(d), 1334, and 2201, claiming that none of the defendants in this action (collectively referred to hereafter as "Spectrum" unless otherwise indicated) are entitled to directors' and officers' ("D & O") liability insurance coverage under Home's Renewal Policy ("Renewal Policy") or Aetna's Excess D & O Liability Insurance Policy ("Excess Policy"). Home and Aetna argue that they are entitled to rescind the Renewal and Excess Policies because Spectrum, through certain of its officers and directors, allegedly made material misrepresentations by failing to disclose in its applications for insurance an informal inquiry initiated by the Securities and Exchange Commission ("SEC") and alternatively, that Spectrum's coverage is precluded by several of the policies' provisions.

 The Court held a bench trial on February 28 and 29, 1996 on the rescission issue. The policy coverage issues are the subject of various partial summary judgment motions. For the reasons that follow, the Court determines that (1) Spectrum did not materially misrepresent or fraudulently conceal information in its application for insurance coverage, and thus, Home and Aetna are not entitled to rescission; and 2) Spectrum's coverage is not precluded by the policy provisions to the extent that the claims are factually unrelated to a pre-existing policy period within the meaning of the Renewal and Excess Policies' exclusionary clauses as fully explained herein.

 I.

 BACKGROUND

 This action arises from the tentative settlement of a consolidated class action brought against Spectrum for alleged violations of the federal securities laws. The settlement includes the payment of approximately $ 10,000,000 to the class members by various parties involved in the litigation and is contingent upon Home's and Aetna's payment of the face amounts of the Renewal and Excess Policies, each in the sum of $ 2,000,000. (See Pl.'s Ex. 86.) The relevant facts -- either undisputed in the summary judgment submissions or determined by the Court as a consequence of the rescission trial -- follow.

 A. 1993 "AT&T Lawsuits"

 In June 1992, Home issued Spectrum a D & O liability and company reimbursement policy ("Original Policy"), which covered the period from June 26, 1992 to June 26, 1993 ("Original Policy Period"). As with all of the policies discussed herein, this policy was issued on a "claims made" basis. *fn1" Aetna did not insure Spectrum during this period.

 In May 1993, Spectrum shareholders who purchased their Spectrum common stock during that month brought several class action lawsuits against Spectrum. The complaints asserted, inter alia, violations of federal securities laws based on Spectrum's alleged May 1993 public misrepresentations of the value of a licensing agreement between Spectrum and AT&T. *fn2" On June 21, 1993, The Honorable Leonard Wexler of the Eastern District of New York issued Pre-Trial Order No. 1 pursuant to Rule 50 of this Court's Rules for the Division of Business among District Judges and Rule 42(a) of the Federal Rules of Civil Procedure, which consolidated most of these lawsuits under the caption In re Spectrum Information Technologies, Inc. Securities Litigation ("AT&T Lawsuits"). (Margulis Aff. Ex. B.) Home has acknowledged coverage under the Original Policy for loss arising from the AT&T Lawsuits. (Home's Mem. Supp. Summ. J. at 3; Home 3(g) Stmnnt. P 6.)

 B. SEC Inquiry

 On May 21, 1993, the SEC sent a letter informing Spectrum that it had initiated an "informal inquiry into recent trading and disclosures involving Spectrum[]" ("SEC Inquiry"), and requested that Spectrum voluntarily produce copies of, inter alia, all press releases issued by Spectrum since the beginning of May 1993, Spectrum's agreement with AT&T, all correspondence between Spectrum and AT&T relating to the agreement, research reports and analyst recommendations issued with respect to Spectrum since the beginning of May 1993, and AT&T's May 18, 1993 press release relating to the technology which was the subject of the agreement. (Ahari Aff. Ex. 7.) The letter stated that the inquiry was "confidential and should not be construed as an indication by the Commission . . . that any violations of law . . . [had] occurred, nor should it be considered an adverse reflection upon any persons, entities or securities." Id. The letter did, however, refer to the SEC's Form 1662, attached to the letter, which described twenty-two routine uses of information provided to the SEC, including the investigation of possible securities laws violations. Id. In a subsequent letter dated October 8, 1993, the SEC requested additional information relating to the AT&T licensing agreement. (Ahari Aff. Ex. 10.) These inquiries allegedly did not become known to the public until January 25, 1994. (Second Am. Compl. P 98; Margulis Aff. Ex. H at 60.)

 C. Home's and Aetna's Applications for the Renewal and Excess Policies

 On May 27, 1993, Spectrum applied for the Renewal Policy for the coming year with Home, the issuer of the Original Policy, and on June 4, 1993, Spectrum applied for the Excess Policy with Aetna, who had not previously insured Spectrum. Spectrum did not disclose the SEC Inquiry in either its application for insurance with Home or Aetna. Nor did Spectrum reveal the SEC Inquiry to Home during a meeting held on June 7, 1993 regarding its application for the Renewal Policy.

 
1. Home's Renewal Policy Application

 Paragraph 7 of Home's application for the Renewal Policy inquired of Spectrum as follows:

 
Has the Applicant Corporation (or any subsidiary thereof) and/or any of its directors or officers been involved in the following within the past eighteen (18) months:
 
(a) any representative action, class action or derivative suit[?]
 
(b) any civil or criminal action or proceeding investigating or charging a violation of any federal or state security law or regulation?
 
(c) any other litigation other than ordinary routine litigation incident to the business of the Applicant Corporation (and/or its subsidiaries) and/or its directors and officers?

 (Joint Pre-Trial Order P 23.) Spectrum answered Paragraph 7(a) in the affirmative and expounded as follows:

 
Recent suits alledge[sic] that Spectrum inflated projected income from a recent AT&T deal. Spectrum feels that the suit is without merit and hopes they will be dismissed.

 Id. at P 24. Spectrum answered "no" to Paragraphs 7(b) and (c). Id. at PP 25-26.

 Spectrum had also completed an application prior to the issuance of the Original Policy in June 1992 which contained the same Paragraphs 7(a), (b), and (c). Consistent with its answer to Paragraph 7(b) on the 1993 application, Spectrum did not disclose the fact that it was subject to a prior informal SEC inquiry, dated October 10, 1990, regarding sales of restricted stock by Spectrum's officers and directors and promotional materials issued by Spectrum between January 1988 and October 1990. (Joint Ex. 6; Pl.'s Ex. 1; Tr. at 233-35.) *fn3"

 2. Aetna's Excess Policy Application

 Paragraph 11(a)(2) of Aetna's application for the Excess Policy contained a similar question to that contained in Paragraph 7(b) of Home's application:

 
Has any person or entity proposed for this insurance been a party to any of the following: . . . . Any civil, criminal or administrative proceeding alleging or investigating a violation of any security law or regulation?

 (Medina Aff. Ex. B). Spectrum provided the same substantive response to this question that it did to Paragraph 7(a) in Home's policy application:

 
Yes. Recent class action suit alleges Spectrum overstated potential revenue from a recent AT&T deal. Attorneys for Insured as well as auditors feel the suit will be dismissed.

 Id. Paragraph 11 further asked:

 
(b) No claims have been made against any person(s) proposed for this insurance in their capacity as a director or officer of the Applicant, except as follows (include loss payment and defense costs. If answer is "none", so state)[.]
 
(c) No person or entity proposed for this insurance is cognizant of any fact, circumstance or situation which they have reason to suppose might afford valid grounds for any claim such as would fall within the scope of the proposed insurance, except as follows (if answer is "none", so state)[.]

 Id. Similar to its responses to Home's Paragraphs 7(b) and (c), Spectrum referred to its answer in Paragraph 11(a)(2) in response to Paragraph 11(b) and answered "none" in response to Paragraph 11(c). Paragraph 11 also contained the following language:

 
Without prejudice to any other rights and remedies of the Underwriter, any claim arising from any claims, facts, circumstances or situations required to be disclosed in response to 11 b) or 11 c), is excluded from the proposed insurance.

 Id.

 On June 26, 1993, Home issued the subject $ 2,000,000 Renewal Policy covering the period from June 26, 1993 to June 26, 1994 ("Renewal Policy Period"), and Aetna issued the subject $ 2,000,000 Excess Policy for the same period.

 D. 1994 Renewal Lawsuits

 Beginning in February 1994, additional lawsuits were commenced against Spectrum (referred to hereafter as "Renewal Lawsuits" because they were brought during the Renewal Policy Period). (Joint Exs. 39, 41-43, 45-46, 49, 75.) Several of these suits contained the same factual allegations as those in the AT&T Lawsuits as well as facts alleged to constitute other security law violations. These lawsuits included: Mathews v. Spectrum, No. 94 CV 1991 (E.D.N.Y. 1994) (Joint Ex. 39), and Bilunka v. Spectrum, No. 94 CV 0529 (E.D.N.Y. 1994) (Joint Ex. 42), brought by plaintiffs who purchased Spectrum common stock from October 1993 through February 1994; Grossman v. Spectrum, No. 94 CV 0448 (S.D. Tex. 1994) (Joint Ex. 41), and Meyers v. Spectrum, No. 94 CV 1507 (E.D.N.Y. 1994) (Joint Ex. 43), brought by plaintiffs who purchased Spectrum common stock, or had options to do so, from May 1993 through February 1994; and Stern v. Spectrum, No. 94 CV 0453 (E.D.N.Y. 1994) (Joint Ex. 75), brought by plaintiffs who purchased Spectrum common stock during January 1994. Although the Renewal Lawsuits assert these additional allegations in a myriad of pleading forms, the allegations contained therein can be grouped into four categories of alleged wrongdoing:

 
1. SEC Inquiry Claims
 
2. Restatement Claims

 The complaints also allege that Spectrum made false and misleading public statements regarding its earnings ("Restatement Claims"): Initially, Spectrum announced profits of $ 0.01 per share for the first and second quarters of fiscal year 1994. It filed its Forms 10-Q with the SEC containing this information on August 16, 1993 for the first quarter and on November 15, 1993 for the second quarter. On February 7, 1994, the same day that Sculley announced his resignation, Spectrum declared that it would restate its earnings for the first and second quarters of the 1994 fiscal year. Because the accounting methods previously used were improper, Spectrum stated that it would report a loss of $ 2,390,000 or $ 0.03 per share for the first quarter, and a loss of $ 5,315,000 or $ 0.07 per share for the second quarter. The complaints claim that certain directors and officers falsely stated Spectrum's earnings to inflate the price of the stock to facilitate their alleged insider trading. (Mathews, Joint Ex. 39 PP 38, 40; Bilunka, Joint Ex. 42 PP 32-39, 56-58; Meyers, Joint Ex. 43 PP 70-71, 84-85, 106.)

 
3. Insider Trading Claims

 The complaints additionally allege that several of Spectrum's officers and directors engaged in insider trading in November and December 1993 by exercising their options to purchase Spectrum stock based on material, adverse information ("Insider Trading Claims"): Peter Caserta ("Caserta"), Vice President and Chairman of Spectrum, exercised options to acquire 1,000,000 shares of Spectrum's stock at $ 1.125 per share and then sold those shares on the open market at an average of $ 9.50 per share; Salvatore Marino ("Marino"), a Director and Vice President of Spectrum, exercised options to acquire 300,000 shares at $ 1.125 per share and then sold those shares in the open market at an average of $ 8.71 per share; Albert Panico ("Panico"), a Director and Vice President of Spectrum, exercised options to acquire 330,000 shares at $ 1.125 per share and then sold those shares in the open market at an average of $ 8.55 per share; and A. Werner Pleus ("Pleus"), a Director and Executive of Spectrum, exercised options to acquire 30,000 shares at $ 1.33 per share and then sold those shares in the open market at an average of $ 8.66 per share. (Mathews, Joint Ex. 39 PP 22-24, 29; Bilunka, Joint Ex. 42 PP 59-71; Grossman, Joint Ex. 41 PP 5-6; Meyers, Joint Ex. 43 PP 20, 78-81, 97; Stern, Joint Ex. 75 PP 20-22, 29.)

 
4. Sculley Claims

 Finally, several of the complaints allege that Sculley made false and misleading public statements ("Sculley Claims"): When Spectrum announced on October 18, 1993 that Sculley, formerly the Chairman of Apple Computer, was to become its next Chairman and CEO, the price of Spectrum stock rose roughly 5 1/2 points to $ 11 1/8 per share. Caserta, Marino, and Panico hired Sculley to inflate the price of Spectrum stock, thereby enabling their insider trading in November 1993. When Dorfman revealed the SEC Inquiry on January 24, 1994, he also reported that Sculley would be resigning from Spectrum. Sculley, as mentioned, falsely denied the SEC Inquiry and additionally announced that he had no plans to leave Spectrum. On February 7, 1994, Sculley announced his resignation from Spectrum. (Mathews, Joint Ex. 39 PP 30-37; Meyers, Joint Ex. 43 PP 73-77, 90-96, 108; Stern, Joint Ex. 75 P 26.)

 E. The Consolidated Action

 After the filing of the Renewal Lawsuits containing the SEC Inquiry Claims, the Restatement Claims, the Insider Trading Claims, and the Sculley Claims, they were consolidated with the AT&T Lawsuits ("Consolidated Class Action Lawsuit"). Subsequently, in February 1994, plaintiffs in this consolidated action filed a Supplemental Consolidated Amended Class Action Complaint (Margulis Aff. Ex. G), and in April 1994, they filed a Second Consolidated Amended Class Action Complaint (Margulis Aff. Ex. H), which each procedurally incorporated all these claims. *fn4"

 F. Relevant Policy Provisions

 Several of the parties' arguments focus on various policy provisions contained in the Renewal and Excess Policies as well as in an additional policy issued by Agricultural Excess and Surplus Insurance Company ("AESIC"). *fn5" (See Margulis Aff. Ex. D; Medina Aff. Ex. B; Ahari Aff. Ex. 20.) The first provision governs whether a claim is first made during the Renewal Policy Period, thereby implicating the Renewal Policy's terms and conditions. Section I of the Renewal Policy, titled "Insuring Agreement" ("Section I ), provides as follows:

 
Subject to the limit of liability, the Insurer shall pay loss arising solely by reason of any wrongful act on or after the policy retroactive date alleged in a claim first made against the assureds and reported in writing to the Insurer during the policy period.

 (Emphasis added.) A "claim" is defined in Section II(B) of the Renewal Policy as "a written demand by a third party for monetary damages, including the institution of suit or a demand for arbitration." "Loss" is defined relative to the amounts paid on claims:

 
The term "loss" shall mean the percentage . . . the assureds are obligated to pay solely by reason of any claim insurable hereunder in respect of their legal liability . . . .

 If a claim is considered first made within the Renewal Policy Period, Home and Aetna then rely on a number of policy exclusions to avoid liability. Section III.B of the Renewal Policy ("Section III.B") provides in pertinent part as follows:

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

 . . . .

 
(B) any circumstances of which notice of claim or potential claim has been reported or for which the assured or the company are entitled to coverage under any insurance policy(s) (including any discovery period applicable thereto) in force prior to policy period[.]

 (Emphasis added.) Another exclusion is Endorsement No. 17 of the Renewal Policy (" Endorsement No. 17"), which provides in pertinent part as follows:

 
The Insurer shall not be liable to make any payment for loss arising from any claim based upon or arising from any essential facts or circumstances underlying or alleged in any manner which prior to the effective date of this policy have been the subject of notice to any "insurance company" of (i) claims, or (ii) threat of claims, or (iii) occurrences or circumstances which might give rise to claims, under any pre-existing policy of which this policy is a renewal or replacement or which it may succeed in time.

 (Emphasis added.)

 A similar exclusion is contained in Endorsement No. 3 of the Excess Policy ("Endorsement No. 3"):

 
In consideration of the premium charged, the Underwriter shall not be liable to make any payment for loss in connection with any claim made against any of the Insureds based on, arising out of, directly or indirectly resulting from, in consequence of or in any way involving:
 
(a) any prior and/or pending litigation as of 6-26-93; or
 
(b) any fact, circumstance or situation underlying or alleged in any prior and/or pending litigation as of 6-26-93.

 (Emphasis added.) Coverage under this provision will be barred if the requirements of either section (a) or (b) are satisfied.

 The final provision containing this type of language is Endorsement No. 2, titled "General Limitation of Coverage," contained in AESIC's policy ("Endorsement No. 2"), which the Excess Policy incorporates:

 
It is understood and agreed that the Insurer shall not be liable to make any payment for loss based upon, attributable to, directly or indirectly arising from, related to, or in consequence of any fact, circumstance or situation which has been the subject of any notice given prior to the effective date of this Policy under any insurance policy providing protection for the Directors and Officers including any matter in any way related thereto.

 (Emphasis added.) *fn6"

 In addition, Home and Aetna rely on Section IV(C), titled " Limit of Liability" of the Renewal Policy ("Section IV(C)"), *fn7" which provides as follows:

 
All claims arising from the same wrongful act or interrelated, repeated or continuous wrongful acts of one or more assureds shall constitute a single claim and shall be deemed to be a claim first made and reported to the Insurer in the policy period in which the first such wrongful act is reported to the Insurer in accordance with Clause VI(A).

 (Emphasis added.) *fn8"

 G. The Parties' Arguments

 Home and Aetna make several arguments in their effort to avoid liability under the Renewal and Excess Policies. First, they argue that coverage is barred because Spectrum failed to disclose the SEC Inquiry when it applied for the Renewal and Excess Policies. Specifically, they contend that Spectrum had a duty to disclose the SEC Inquiry in response to Paragraphs 7(b) and (c) of Home's Renewal Policy application and Paragraphs 11(a)(2) and (c) of Aetna's Excess Policy application, and that its failure to do so constitutes grounds for rescission. Home additionally claims that Spectrum's failure to disclose was fraudulent. Spectrum denies that it had an obligation to disclose the SEC Inquiry, and that, in any event, its nondisclosure was not material or justifiably relied upon by Aetna or Home to warrant rescission.

 In the alternative, Home and Aetna rely on several policy provisions. They first argue that Spectrum has not filed a "claim" within the Renewal Policy Period. In that regard, they contend that a "claim" within the meaning of Section I of the Renewal Policy means the Consolidated Class Action Lawsuit, and therefore owes its genesis to the Original Policy Period when the AT&T Lawsuits were commenced. Spectrum, on the other hand, asserts that the additional allegations contained in the Renewal Lawsuits -- namely, the Restatement Claims, the Insider Trading Claims, and the Sculley Claims -- are distinct "claims" from the AT&T Lawsuits and the SEC Inquiry Claims, which they admit are not covered by the Renewal or Excess Policies, and that these distinct "claims" were first made in February 1994, during the Renewal Policy Period.

 Home and Aetna then argue that, even if the Restatement Claims, the Insider Trading Claims, and the Sculley Claims are distinct "claims" which were first made within the Renewal Policy Period, they are excluded from coverage by several of the policies' exclusions because they generally arose from the same facts and circumstances and underlying the AT&T Lawsuits. Spectrum disagrees, contending that these are separate claims and are based on factual circumstances distinct from the claims contained in the AT&T Lawsuits.

 H. Issues for the Court to Resolve

 The Court's determinations are therefore predicated upon the resolution of the following issues: (1) whether Home and/or Aetna are entitled to rescission; if not, (2) whether the Restatement Claims; the Insider Trading Claims, and/or the Sculley Claims constitute claims first made during the Renewal Policy Period; and if so, (3) whether the ...


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