D&O Severability and Imputation: Protecting Innocent Directors When One Executive Commits Fraud

A privately held medical device distributor discovers that its CFO has been hiding losses and overstating revenue for two years. The board removes him and hires outside counsel to investigate. Preferred shareholders then sue the company, the CEO, and three outside directors, claiming management misrepresented the company’s finances.

The outside directors say they relied on financial reports they had no reason to doubt. The company’s D&O insurer responds that the CFO knew about the fraud, and that his knowledge defeats coverage for everyone.

One executive’s fraud doesn’t automatically eliminate coverage for the rest of the board. The answer depends on how the policy handles one insured’s knowledge and conduct.

Whose Knowledge Counts

D&O policies often say when one person’s knowledge is attributed to others, a concept called imputation. A common approach attributes the knowledge of top executives, such as the CEO or CFO, to the company itself, while protecting individual directors from having another person’s knowledge attributed to them.

Under that kind of provision, the insurer may have grounds to deny coverage to the CFO, and possibly to the company, without having the same grounds against an outside director who never knew the numbers were false. But policies often use different imputation rules for different issues. A rule about the application may not govern the fraud exclusion or a prior knowledge condition. The analysis has to start with the specific provision the insurer is relying on.

Severability Separates the Insureds

Severability provisions decide whether one insured’s statements or conduct affect coverage for others. Two kinds matter most.

Application severability concerns statements made when the policy was purchased. If the application included the CFO’s false financial statements, the insurer may try to rescind the policy, meaning cancel it from the start. A severability provision may limit rescission to the people who actually knew the statements were false.

Illinois law adds a further limit. Under Section 154 of the Illinois Insurance Code, a misrepresentation in an application doesn’t void a policy unless it was made with actual intent to deceive or materially affected the insurer’s acceptance of the risk. Some policies go further and make Side A coverage for individuals non-rescindable altogether.

Severability of exclusions determines whether excluded conduct by one insured, such as fraud, affects anyone else’s coverage. Some policies protect innocent directors broadly. Others permit the knowledge of specified executives to be attributed to the company. A heading labeled “severability” isn’t enough. What matters is what the provision actually separates and what exceptions it contains.

An Accusation of Fraud Isn’t a Finding of Fraud

Most D&O policies exclude deliberate fraud, but many apply that exclusion only after a final adjudication establishes the misconduct.

In USA Gymnastics v. Liberty Insurance Underwriters, Inc., 27 F.4th 499 (7th Cir. 2022), the Seventh Circuit, applying Indiana law, limited a conduct exclusion to claims tied to misconduct that had actually been adjudicated, rather than every claim connected to it. The policy’s wording drove the result.

Policies differ on where that adjudication must happen. Some require a final judgment in the underlying lawsuit. Others allow the insurer to prove the misconduct in a separate coverage case. Until the required finding exists, the allegations alone may not support the exclusion.

Defense Funding for Each Director

Even when the insurer contests coverage for the CFO, the other directors may be entitled to have their defense costs advanced. If the complaint accuses the CFO of intentional fraud and the outside directors of failing to supervise, the insurer has to evaluate each defendant’s status, the conduct alleged against each, and the exclusions as they apply to each.

Advancement may still be subject to retentions, allocation, insurer consent, and repayment if a claim is later found uncovered. But a coverage fight over the CFO shouldn’t cut off defense funding for directors who aren’t accused of knowing participation.

The Evidence That Separates Directors

The company’s investigation often provides the key evidence. Board materials, audit reports, minutes, any internal warnings, and communications about the disputed numbers show what each director received, when they received it, and whether anyone raised concerns. That record separates knowing participation from reasonable reliance and helps defend against claims of weak oversight.

It is reasonable to ask the insurer to identify, in writing, each provision it relies on and how that provision applies to each insured. A strong response treats the company, the CFO, and each director separately, and addresses the application, the conduct exclusions, and advancement as distinct issues.

This article provides general information and does not constitute legal advice. For guidance concerning a specific matter, see our insurance recovery services. Coverage depends on the policy wording, the facts, and applicable law. To discuss potential representation, request a consultation. Submitting an inquiry does not establish an attorney-client relationship.