March 17, 2010
Written by The National Insurance Coverage Group of NLdH
This article is an interpretation of current law and is offered for informational purposes only. This material is not legal advice and should not be construed or used as a substitute for the advice of an attorney.
The flagging American economy has focused significant attention upon corporate governance and the conduct of corporate directors. One area critical to insurers is the conduct and accountability of corporate directors in the procurement of D&O policies. Several recent court decisions have addressed the rescission of directors & officers policies, a specific topic that has significant potential to generate litigation in the months and years to come.
Indeed, the very conduct that may give rise to a significant claim under a directors & officers policy may also form the basis for rescission of the policy. A recent decision from the United States Court of Appeals for the Tenth Circuit bears this out. In ClearOne Communications, Inc. v. National Union Fire Ins. Co. of Pittsburgh, Pa., 494 F.3d 1238 (10th Cir. 2007), a corporation was issued a D&O policy after submitting an application that included a recent financial statement. Several months after the policy incepted, the policyholder corporation publicly acknowledged that the financial statement was inaccurate, leading to a number of shareholder lawsuits for which the corporation sought coverage under the D&O policy. However, the insurer rescinded the policy on the grounds that the financial statement constituted a material misrepresentation.
The corporation, Clear One, and one of its directors subsequently brought an action against the insurer for breach of contract and bad faith. Holding that the policy was properly rescinded, the United States District Court for the District of Utah granted summary judgment in the insurer's favor. On appeal, the Tenth Circuit rejected the policyholder's contention that the financial statement should not be considered part of the policy application. Noting that the application expressly stated that any supporting documents would be deemed incorporated in the application, the Court held that nothing under Utah law precluded the documents from being deemed part of the application.
The Court also held that the misrepresentations set forth in the financial statement were material to the insurer's decision to issue coverage, noting that it could "not see how [the policyholder's] financial records, which give an account of the financial health of the company, could not influence [the insurer's] assessment of the company's risk." ClearOne Communications, 494 F.3d at 1250. In addition, the Court found that the insurer was justified in relying upon the misrepresentations, noting that "[n]o disputed facts suggest [the insurer] failed to investigate adequately the financial information it was provided." Id. at 1251.
Despite its ruling as to the materiality of the misrepresentations and the insurer's justified reliance, the Court held that the trial court erred by failing to analyze whether the individual who actually signed the application (the president and chief executive officer of the policyholder) knew or should have known about the misrepresentation. While the Court remanded the case for resolution of this issue, it suggested how this issue would likely be resolved by noting that "[i]n the corporate context, corporate directors have a general obligation to know the financial condition of their corporations." Id. at 1248.
Similar issues were addressed in TIG Ins. Co. of Michigan v. HomeStore, Inc., 137 Cal. App. 4th 749, 40 Cal. Rptr. 3d 528 (2 Dist. 2006), which also arose from a policyholder corporation's determination and disclosure that one of its financial statements was inaccurate, which in turn led to a wave of litigation against the corporation and its directors and officers. The D&O insurer brought an action seeking to rescind coverage, on the grounds that the corporation's chief financial officer knew or should have known that the financial statement was inaccurate at the time he signed the policy application, which included a copy of the statement.
The California Court of Appeals affirmed the trial court's decision granting summary judgment in the insurer's favor. In so doing, the Court rejected the policyholder's argument that rescission was improper in light of the fact that neither the corporation nor the remaining directors and officers were aware that the clear and unambiguous language of the policy in question established that the policy could be rescinded with regard to all directors and officers in the event of a knowing and material misrepresentation by the individual who signed the application. The Court observed that while some D&O policies contain language expressly providing that material misrepresentations by the individual who signed the application will not serve as grounds for rescission with effect to innocent co-insureds, such language was not contained in the policy at issue, and the policyholders' "decision to purchase a policy without such a provision does not offend public policy." HomeStore, 137 Cal. App. 4th at 759, 40 Cal. Rptr. 3d at 536.
The Court further held that the corporation's "grossly misrepresented financial condition was material to the acceptance of the risk as a matter of law," given the testimony of the insurer's underwriter that he "relied on the financial information" in question "in making the decision to issue the D & O policy," as well as the underwriter's testimony that "he attended a client meeting ... where that financial information was discussed." HomeStore, 137 Cal. App. 4th at 762, 40 Cal. Rptr. 3d at 538.
While inaccurate financial statements have been squarely recognized as a basis for rescinding a D&O policy, there are some limits to this general approach. For example, in National Fire Ins. Co. of Pittsburgh, Pa. v. Xerox Corp., 792 N.Y.S.2d 772 (New York Co. 2004), an insurer brought a declaratory judgment action seeking to rescind a D&O policy due to its purported reliance on the policyholder's inaccurate financial statements, despite the fact that the insurer issued coverage without requiring the policyholder to submit an application or formally submit its financial statements for review. A New York trial court rejected this argument, noting that the policy "provides coverage for claims arising from conduct, such as the filing of false financial statements, occurring prior to the Policy period." Xerox, 792 N.Y.S.2d at 775. The Court therefore held that the D&O insurer was "precluded from claiming reliance on financial statements that were not part of any application upon which the Policy was issued." Id. Accordingly, the Court granted the policyholder's motion to dismiss the insurer's rescission claim.
Although an insurer may be precluded from rescinding policies based upon inaccurate financial statements that were never requested as part of the policy application, this does not mean that a policyholder can avoid rescission entirely simply by failing to attach requested documents to the application. Such a "loophole" was addressed by the United States District Court for the Western District of Washington in Cutter & Buck, Inc. v. Genesis Ins. Co., 306 F. Supp. 2d 988 (W.D. Wash. 2004), in which a policyholder challenged a rescission of a directors & officers policy that was based upon inaccurate financial statements and related documents that the policyholder was required to submit with the policy application. The policyholder failed to attach any of the required documents to the policy application, and produced only a few of these documents upon the insurer's subsequent request. Prior to issuing coverage, the insurer obtained and reviewed the remaining documents (which were publicly available SEC documents) through the Internet.
The Court held that the applicant's signature on the policy application stating that "‘the statements herein are true and complete'" applied not only to the statements in the application itself, but the statements in the documents required to be produced, given policy language indicating that the insurer will "‘rely upon this application and attachments in issuing the policy.'" Cutter & Buck, 306 F. Supp. 2d at 997 (quoting policy application). The Court further observed that the policyholder's failure to attach the documents to the application was "not dispositive because [the policyholder] had unequivocal notice that [the insurer] would rely upon those documents in issuing the policy." Id. at 998 n. 3. The Court noted that it would be "disingenuous for [the policyholder] to fail to provide the required documents in a timely fashion, thereby forcing [the insurer] to access them through another means, and then take refuge in their failure by claiming that they never attached these documents." Id. Because the record indicated that the misrepresentations contained in these documents were material to the risk and were made intentionally by the corporate officer who signed the policy application, the Court concluded that the insurer's decision to rescind coverage was justified.
In order to justify rescission, courts will generally require proof that material misrepresentations were made intentionally or, in some states, recklessly. However, even if the alleged misrepresentations or non-disclosures made on a policy application fail to justify rescission, they may nonetheless warrant denial of a claim under certain circumstances. This was illustrated by the Kansas Supreme Court's recent decision in American Special Risk Management Corp. v. Cahow, 286 Kan. 1134, 192 P.3d 614 (2008). In Cahow, a bank applied for a D&O policy with an errors & omissions (E&O) endorsement, shortly after learning of a criminal investigation concerning allegations that a bank employee diverted money from an account holder into his own account. Despite its knowledge of these allegations, in response to a question on the policy application asking whether the insurer was aware of any "facts, circumstances or situations involving the [policyholder], any subsidiary or any past or present director, trustee, officer or employee which could reasonably be expected to give rise to a claim," the bank answered in the negative Id. at 1136, 192 P.3d at 618. The application further stated that "if knowledge of any fact, circumstance or situation exists, any claim or action subsequently arising therefrom is excluded from coverage." Id. Shortly after the policy was issued, a lawsuit was filed against the bank regarding the incident. The insurer did not accept coverage on the loss, but did not expressly deny coverage or rescind the policy.
The tort victim ultimately settled with the bank and pursued a garnishment action against the insurer, arguing that under Kansas law pertaining to rescission, in order to avoid coverage on the claim the insurer needed to present "clear and convincing evidence" that the policyholder knowingly made a false statement on the application. The Court rejected this argument, noting that the insurer did not seek to rescind the policy, but rather sought to enforce the exclusion for known losses set forth in the policy application. Interpreting the language of the exclusion, the Court instead examined whether "substantial competent evidence" existed to support a finding that the bank had knowledge of information that could reasonably be expected to give rise to a claim. As the record supported such a finding, the Court affirmed the trial court verdict granting judgment in favor of the insurer.
As the economic crisis continues, courts are likely to be presented with a variety of issues involving D&O coverage. Recent developments have shown that while D&O exposure can be significant, courts are willing to closely scrutinize the information provided by a policyholder in connection with their application for coverage, and consider whether or not the policyholder provided the requested information fully and accurately and, if not, whether rescission of the policy is warranted. For their part, insurers need to undertake appropriately detailed due diligence before agreeing to insure institutional risks, which includes asking the right questions and thoroughly reviewing prospective policyholders' financial statements.
