Axis Insurance Loss Poses Rare Question About Director Fraud

A clash between a payment technology company and an AXIS Capital Holdings Ltd. insurance unit over legal defense payments is teed up for a rare trial that will highlight executives’ knowledge of potential fraud.

A federal judge in Pennsylvania last week reaffirmed her decision calling for a jury to assess what Cantaloupe Inc.'s leaders knew about inflated sales and federal securities regulators’ probes when applying for directors and officers insurance. The court refused to rule that a widely used “prior knowledge” exclusion relieves Axis Insurance Co. of its duty to foot the bill for the payment company’s legal troubles.

The Pennsylvania court’s closely watched ruling and the upcoming trial could give businesses and their directors some leeway to seek coverage for alleged wrongdoing that took place before the policy period began, insurance and policyholder attorneys say.

“The court’s reading is troubling,” said Mike Manire of Manire Galla Curley LLP, who represents insurers. If a company has a problem before buying insurance, its executives can “just have the CEO make a speech saying there is nothing material about what’s going on” and the company can still qualify for coverage, he said.

Although the Cantaloupe directors knew about the potential fraud before they bought insurance, they testified they didn’t expect Securities and Exchange Commission and Justice Department subpoenas or class actions that would trigger insurance claims, the Pennsylvania court said. Pennsylvania-based Cantaloupe—formerly known as USA Technologies Inc.—made a $70 million secondary stock offering in May 2018 based on fake sales numbers, according to the suits.

The court’s take is unusual and contradicts previous rulings on D&O insurance, attorneys who represent insurers say. A 2009 ruling from the US Court of Appeals for the Tenth Circuit on the same prior knowledge exclusion with similar underlying facts held the opposite, Axis argued.

“I’ve seen plenty of cases on the prior knowledge exclusion; I’ve never seen it done quite this way” in D&O insurance, Manire said.

High Bar

District Judge Gene E. K. Pratter’s initial ruling against Axis “does set a high bar for insurers to prevail on a prior knowledge exclusion,” said Paul Curley, a Kaufman Borgeest & Ryan LLP partner who represents insurers. Although it isn’t binding on other jurisdictions, the November decision will likely be cited in other D&O coverage battles, he said.

The decision will embolden companies to push for jury and bench trials when there are disputed facts over what their directors knew about alleged fraud, said Geoffrey B. Fehling, a partner at Hunton Andrews Kurth who represents policyholders.

Insurance doesn’t cover events that occur before a policy period kicks in. Cantaloupe’s D&O policy specifically bars coverage for claims that executives were aware of before the policy started. But the question is: how does an insurer prove directors knew about potential wrongdoing that could trigger enforcement actions or litigation at the time they bought insurance?

It isn’t uncommon for companies to buy coverage quickly after getting a whiff of malfeasance. Ozy Media Inc. applied for a D&O policy in August 2021, a month before The New York Times exposed that its CEO Carlos Watson defrauded investors. FTX, the collapsed crypto exchange, bought its D&O insurance two months after it created seven alternative balance sheets for investors.

In Cantaloupe’s case, directors didn’t know how bad the accounting errors were until after buying insurance protections, the company has said. They realized the company would miss a deadline to file its 10-K annual report with the SEC in August 2018, just days after purchasing the D&O policy, Cantaloupe said.

Showing that a company’s directors knew about misconduct isn’t enough for insurers to deny coverage, said Bradley Nash, a partner at Hoguet Newman Regal & Kenney, LLP who represents policyholders. “All the time companies get accused of wrongdoing,“ he said.

Other policyholder attorneys shared similar views.

“Hopefully, this will keep insurance companies from jumping the gun and looking for ways to avoid coverage,” said Diana Shafter Gliedman, an Anderson Kill shareholder who represents policyholders.

‘Subjective Belief’

Cantaloupe executives reasonably expected shareholder claims and regulatory subpoenas in July 2018 when they purchased the $5 million D&O policy, Axis said. Priyanka Singh, Cantaloupe’s chief financial officer at the time, had already warned the company of SEC whistleblower lawsuits alleging fake sales, and she hired her own attorney to deal with potential risks a few weeks before the insurance period started, Axis said.

The court should have focused on whether the directors knew the problems existed, instead of what they believed, the insurer said.

Allowing businesses to manipulate coverage by “asserting their subjective belief” that an allegation lacked merit could encourage companies to conceal fraud, Axis said.

Other industry attorneys agreed.

“In any case, if you muddy the waters enough, you could create some question of fact about what people subjectively understood at the time,” said Michael Steinlage, a Larson King LLP partner who has represented both insurers and policyholders.

A public company is never going to say it believes certain facts are bad, Manire said. “That’s how businesses operate: anytime you get sued, you’re going to say it’s not material,” he said.

Affeld Grivakes LLP and LeVan Stapleton Segal Cochran LLC represent Cantaloupe. Werner Ahari Mangel LLP represents Axis.

The case is Cantaloupe v. Axis, E.D. Pa., 2:22-cv-00030.