The opinion of the court was delivered by: Arthur J. Schwab United States District Judge
This is a breach of contract and declaratory judgment action. Plaintiffs, MDL Capital Management, Inc., ("MDL"), Mark Lay ("Lay"), Steven Sanders ("Sanders"), and Edward Adatepe ("Adatepe") (collectively referred to as "MDL"), who sought and obtained commercial insurance coverage (through a "Binder") with Federal Insurance Company ("Federal"), seek damages and a declaration that Federal should defend and indemnify at least $5 million for claims asserted against plaintiffs in federal court litigation in Ohio for their alleged wrongdoing regarding investments they made on behalf of their client, the Ohio State Bureau Workers' Compensation Bureau ("the Bureau").
This Court previously resolved summary judgment in favor of defendant and against plaintiffs on the parties prior cross-motions for summary judgment, finding that the policy did not provide insurance coverage based upon certain exclusions in the Errors and Omissions ("E & O") Coverage Forms and the Directors and Officers ("D & O") Coverage Forms. Plaintiffs, thereafter, appealed the judgment of this Court denying coverage for liability claims under the two separate policy binders. On April 2, 2008, the United States Court of Appeals for the Third Circuit affirmed this Court's holding that plaintiffs were not entitled to D & O coverage, but found that this Court erred in giving effect to an exclusion contained in the E & O policy, and thus affirmed in part, reversed in part and remanded for further proceedings. (See Doc. No. 160). In the Per Curiam Opinion, while the United States Court of Appeals reversed this Court's decision on the E & O policy, it noted that the reversal was, "without prejudice to other contentions of the parties with respect to the E & O binder, including allegations of misstatements in the application for insurance." (Doc. No. 161). Upon remand, and following a status conference before this Court after hearing the positions of the parties, the Court issued a renewed briefing schedule for further motions for summary judgment. (Doc. Nos. 163-167).*fn1
Currently pending before this Court are the parties cross-motions for summary judgment (doc. nos. 173, 179). Plaintiffs again seek summary judgment as to liability arguing that the E & O policy provides coverage as a matter of law. Defendant also moves for summary judgment and contends that: (1) the application warranty exclusion in the application on which Federal relied bars coverage for all plaintiffs; (2) the criminal conviction of MDL's Chief Executive Officer, Mark D. Lay, for investment adviser, mail and wire fraud stemming from his dealings with the Bureau and trades in the ADF conclusively establishes the applicability of the application warranty exclusion; (3) Federal properly rescinded the conditional binder based on undisputed misrepresentations in the application process; (4) the dishonesty exclusion in the conditional policy bars coverage for MDL and Mr. Lay based on Mr. Lay's conviction; and (5) the personal profit exclusion in the Binder bars coverage for MDL and Mr. Lay based on Mr. Lay's conviction.
After careful consideration, and for the reasons that follow, this Court will grant defendant's motion for summary judgment (doc. no. 173), and will deny plaintiffs' motion for summary judgment (doc. no. 179).
In the parties' cross-motions for summary judgment, they amass over 100 pages of facts. The undisputed material facts may be fairly summarized as follows.
A. MDL's Establishment and Management of the ADF
In May, 1998, MDL entered into an agreement with the Bureau whereby MDL agreed to perform professional investment advisory services for and on behalf of the Bureau. From 1998 to 2005, MDL provided professional investment advisory services to the Bureau in connection with a long bond account. See Joint Statement of Facts Not in Dispute and Responses Concerning Plaintiffs' Motion for Summary Judgment on E & O Coverage (doc. no. 189) at ¶17. Sometime between 2002 and 2003, MDL formed the MDL the ADF, and the Bureau was the sole investor in the ADF. In May 2002, Mr. Lay incorporated the ADF in Bermuda as an investment vehicle through which United States investors and non-United States investors could invest in a portfolio consisting primarily of government, corporate and mortgage-backed fixed income securities. In the years 2003 and 2004, the Bureau invested $225 million in the ADF. See Joint Statement of Facts Not in Dispute and Responses Concerning Federal Insurance Company's Motion for Summary Judgment (doc. no. 183) at ¶ 19-20; See also, Id. at ¶¶ 17-19.
The Terms of the Private Placement Memorandum
A Private Placement Memorandum ("PPM") governed the management of and investment in the ADF. The PPM permitted leveraging in certain circumstances such as "short selling of securities, reverse repurchase agreements, certain options on future transactions . . . plus borrowings." The PPM specifically stated, that "up to 150% of the Fund's assets (other than U.S. Treasury Securities), at the time of investment may be leveraged (i.e. the combined value of borrowings and short positions) . . . . The percentage referenced above is intended as a 'guideline' and may be changed from time to time at the sole discretion of the Board of Directors." See Joint Statement of Material Facts Not in Dispute and Responses Concerning Federal Insurance Company's Motion for Summary Judgment (doc. no. 183) at ¶ 21.
According to the testimony of Bureau official, Terrence Gasper, during the criminal trial of Mr. Lay, in a conversation he allegedly had with Mr. Lay, it was envisioned that the Fund would typically be leveraged at 100%, but Mr. Lay outlined a 150% "limit" to give the Fund some flexibility.*fn2 Id. at ¶ 22.
The Bureau Officials and MDL Officers Express Concerns About Management of the Fund
In late 2003 and early 2004, concerns were voiced to Mr. Lay, who primarily managed the ADF, about the declines in the ADF's net asset value and MDL's use of leveraging activities. MDL's Chief Investment Officer Ed Adatepe described a number of discussions which he had with Mr. Lay about the ADF's use of leveraging as "heated" and "aggressive." Mr. Adatepe testified that he "went in and said, Mark, please, for the love of God, tell me you are sure, absolutely positive that this Fund is allowed to be over 150 percent?" Plaintiffs do not dispute that Mr. Adatepe so testified; rather, they argue that the language of the PPM allowed changes above 150% and that the number was meant only as a "guideline." Id. at ¶ 23.
Defendant alleges that on April 23, 2004, James McLean (the Bureau's Chief Financial Officer) and Mr. Lay met to discuss the Fund's loss of $7.5 million in March 2004. Defendant further alleges that from April through July 2004, James McLean repeatedly asked MDL for reports that provided greater detail about the activity in the ADF "in light of his concerns about the lack of transparency." Id. at ¶25. Plaintiffs, however, dispute the contention that there was a lack of transparency, and cite the deposition testimony of Mr. Lay to support its contention that MDL was in constant communication with the Bureau about the activities of the ADF and that there was "complete transparency with the [Bureau]". Id. at ¶¶ 24-25.
Mr. Lay Attempts to Obtain an Amendment to the PPM
According to the ADF Board of Director Meeting Minutes from May 18, 2004, the accuracy of which plaintiffs do not dispute, the ADF Board of Directors called a meeting (at which Mark Lay, Ed Adatepe and Steven Sanders were present) "primarily as a result of concerns with the decline in the Fund's net asset value in the months of March and April." The Board questioned Mr. Lay about his use of leverage in the Fund. Mr. Lay did acknowledge that "it was possible that the 150% leverage limitation might have been exceeded on an intra-day trade basis." Id. at ¶ 26-27 (emphasis added). Plaintiffs do not dispute the existence or accuracy of the meeting minutes, rather they repeatedly cite the PPM itself and state that the leverage provision in the PPM was simply a guideline and not a limitation which could not be exceeded.
Nonetheless, while Mr. Lay assured the Board that the Bureau was well aware of the leveraging practices, the Board still insisted that Mr. Lay obtain an amendment to the PPM, and so, on August 11, 2004, the ADF submitted a proposed revised PPM and cover letter to the Bureau containing "clarifications" to ADF's leveraging practices. Plaintiffs also do not seriously dispute the contents of this letter or the revised PPM, they simply continue to cite the original PPM to support their contention that it gave the ADF the right to change the leverage percentage. Id. at ¶ 29.
The proposed revised PPM altered the language of the original leverage limitation to state that "the maximum amount of leverage the Fund intends to employ with regard to assets other than U.S. Treasury Securities will be up to 150% of the Fund's assets, excluding its U.S. Treasury Securities holdings) . . . . In the case of U.S. Treasury Securities, the amount of leverage utilized by the Fund can, and will, be significantly higher in most cases." Id. at ¶ ¶ 29-30. The cover letter concluded by seeking the Bureau's concurrence with the revised PPM. Id.
Mr. McLean testified in the criminal trial that he considered the revised PPM as "an admission of guilt" because it conceded that for U.S. treasury securities "leveraging has been and will continue to be significantly higher than 150%." Id. at ¶ 31.
The Bureau, however, refused to sign the proposed revised PPM. MDL's president, Steven Sanders testified that the situation with the ADF "started to go south"in the third and fourth quarters of 2004. Mr. Sanders questioned Mr. Lay about the Fund's losses, and in response, "Mark . . . asked me, [']Look, you know Steve, I need your support on this . . . . [Can you pray with me [?'] I'd pray, he'd trade, he'd call me back, we'd pray some more, he'd trade, and you know, he'd tell me that I was there to encourage him." Id. at ¶ 34
Bureau Officials Again Confront Mr. Lay About the Fund's Staggering Losses
According to defendant, on September 16, 2004, Messrs. Gaper and McLean of the Bureau confronted Mr. Lay about the Fund's poor performance, which by this time had lost nearly three quarters of its value. During the meeting, Mr. Lay revealed that the Fund was leveraged an estimated 1,000% rather than 150%, and that the Fund had a short position in 30-year U.S. treasuries of $1.7 billion. Plaintiffs counter, not by denying these facts and statistics, but instead by offering the standard reverence to the original P.M., stating that MDL had no knowledge of any future claims by the Fund, and they cite the deposition testimony of Mr. Lay who stated that there was "complete transparency" with the Bureau. Plaintiffs further argue that the Bureau's continued investment of $164 million through June or July of 2005 "clearly supports the fact that MDL Capital had no reason to believe that the Bureau was intending to assert a claim against MDL Capital." Id. at ¶ 35.
According to defendant, the Bureau officials (Messrs. Gaper and McLean) testified that they were "quite agitated" and expressed their extreme reservations about the Fund's leveraging practices in a meeting with Mr. Lay. Mr. McLean testified that the fact the Fund was being managed now with a $1.7 billion short position when the limitation should have been $100 million, was "just incredible, beyond, beyond the imagination, a leverage that [he] referee] to as obscene." Id. at 36. Mr. McLean further testified that Mr. Lay responded to the effect of "Well, I guess I'm in trouble now." Id. at ¶ 36. Plaintiffs dispute these contentions, and restate Mr. Lay's deposition testimony that he was in constant communication with the Fund and the Bureau was informed of every trade at weekly meetings, that on several occasions, the Bureau invested additional money (up to millions of dollars) to cover the leverage positions, and that there was "complete transparency." Id. at ¶ 36.
In the week after the meeting between the Bureau officials and Mr. Lay, Mr. Lay requested an emergency infusion of $25 million to answer a margin call and to avoid a potential loss of $200 million. Mr. Gaper testified that he agreed to have the Bureau supply the money because he felt he had no other choice. Id. at ¶ 37.
The Bureau Requests Redemption of Its Investment in the Fund
On September 29, 2004, MDL informed the Bureau that it needed an additional investment of $30 million to cover a margin call. On the day the Bureau refused to provide the money, the Bureau learned from the Fund's top broker, Credit Suisse First Boston, that the ADF was massively over-leveraged, in the amount of $3.72 billion in the 30-year U.S. treasury long bond alone. The Bureau then formally requested redemption of its investment in the Fund. The Fund, however, was so heavily leveraged that the Bureau gave MDL 90 days to unwind the Fund because selling $3.7 billion of U.S. treasuries in a short amount of time would have been a "shock to the market" and would have created an "imbalance in the treasury market." Id. at 39.
The Board of MDL Calls a Meeting to Address the Problems with the Fund
On October 27, 2004, the Board conducted a meeting which was described as "intense." The meeting was attended by plaintiffs Mark Lay, Steven Sanders and Ed Adatepe. According to the meeting minutes, the Board expressed alarm about the utilization of leverage and questioned MDL's "highly unusual" trading practices. Id. at ¶ 40. During this meeting, the minutes stated that Ms. Murray-Brown:
[explained that in the view of the corporate directors there seemed to be some confusion on [MDL's] part regarding the difference between the Fund's permitted strategy and the overall strategy of [the Bureau] and that [of MDL]. Ms. Murray-Brown suggested that in light of the information provided at [the Board] meeting perhaps it would have been more prudent for the Fund's Offering Memorandum to have been more reflective of the actual practices of [MDL] and [the] sole shareholder. . . . She further advised that the Warwick and Hamilton directors were concerned about the following: (I) whether [MDL] is trading outside of the Fund mandated parameters as outline in its [P.M.] and (ii) the fact that there is no guarantee that the sole shareholder will continue to supply the capital required to cover losses or collateral requirements. A discussion ensued regarding the potential liability of the Fund, the Investment Manager [MDL] and the directors [which included Messrs. Lay, Sanders and Adatepe.]
Id. at ¶ 41 (emphasis added).
It bears repeating that the meeting minutes of October 27, 2004 specifically state that the Board discussed potential liability of the Fund, and plaintiffs do not dispute the accuracy of the meeting minutes.
The Bureau Refuses to Provide Any Further Investments in the Fund and Announces an Audit of the Fund
In the October 2004 ADF board meeting, Mr. Lay acknowledged that he needed approximately $50 million additional capital to cover future margin calls. Id. at ¶ 42. On the same day, Mr. Lay met with Messrs. McLean, John Annarino (the Bureau's Chief Legal Counsel), Jerry Jackson (the Bureau's media liaison) and two lawyers from the law firm Schottenstein, Zox and Dunn, as well as Ken Brunk, a consultant. Id. at ¶ 43. During the meeting and in writing thereafter, Mr. Lay requested that the Bureau provide half of the amount necessary to cover future margin calls. Mr. Annarino responded by stating, "I will tell you what, I am not giving you the money." Id. at ¶ 44.
In October 2004, the Bureau and its auditors went to MDL's offices to review MDL's trade records. Id. at 45. According to plaintiffs, Mr. Adatepe spent about 10 minutes with the representative from the Bureau and the auditor and Mr. Lay told Mr. Adatepe the day after the meeting that "everything was fine." Id. at ¶ 45.
Having already lost more than $215 million, the Bureau refused to invest any new funds in the ADF after November 2004. The Bureau then hired outside counsel to investigate its investment in the ADF and by letter sent on November 1, 2004, lawyers for the Bureau demanded a broad range of information regarding the investment in the ADF, including any evidence that the Bureau ever agreed to leverage in excess of 150% in its account. Mr. Lay, however, testified that the contact from outside counsel and the audit was not a concern to him and that because MDL managed other products for the Bureau, "[t]here was no reason for [MDL Capital] to - for me or anyone else to read anything into that." Id. at ¶¶ 46-47.
By letter dated December 28, 2004, the Bureau confirmed a telephone call with Mr. Lay and others that it would be hiring an accounting firm to audit the ADF's records and the letter reserved "all rights and remedies available to it under the Fund documents and at law." Id. at ¶¶ 48-49.
B. The Federal Policy Binder
During the period from May 2003 to May 2005, American International Specialty Lines Insurance Company (AISLIC) provided Investment Advisers E & O coverage and D & O insurance coverage to MDL with a combined limit of liability of $10 million.*fn3 MDL, worked through a broker, Seubert & Associates, to obtain a renewal of coverage. According to plaintiffs, Seubert also used the renewal application process to shop for coverage from other insurance companies because the costs of the premiums with AISLIC were too high. While MDL completed an application for renewal ...