Laurence J. Stybel

Even Innocent Directors and Officers May See D&O Policies Rescinded

This article comes to www.boardoptions.com via Piper Rudnick.

By Shirli Fabbri Weiss and Nathaniel D. McKitterick

When may a directors and officers liability policy be rescinded (revoked) by the insurer? This question, of great concern to insurers and insured directors and officers alike, was answered by the Ninth Circuit's recent affirmances of two unpublished District Court decisions from Washington and California. In those decisions, Federal Ins. Co. v. Homestore and Cutter & Buck v. Genesis Ins. Co., the Ninth Circuit held that an individual's fraudulent manipulation of a company's financial statements may justify rescission of the D&O policy as to all insureds, even the "innocent" insureds. These decisions may prove significant in several ways.

Rescission is the complete voiding of an insurance policy ab initio, so that it is as if the policy were never purchased, leaving all or some of the insureds without insurance coverage. It may occur where there is a material error, however innocent, in the application and associated materials. Rescission, though an extraordinary action for the insurer to take, may occur after a claim has been made against the insureds by, for example, aggrieved shareholders and/or government regulators. Directors and officers affected by that rescission would be left to rely solely on indemnification (which may or may not be approved) by a company that may be facing financial adversity, with the value of such indemnification being lessened the closer the company is to insolvency or bankruptcy.

Rescission May Not Require Intent To Deceive

First, the Ninth Circuit has endorsed a lower bar for rescission than some policyholders had championed. Homestore, applying California law, held that an insurer may rescind a D&O policy if it is able to demonstrate that it relied on a misrepresentation in the application for insurance (including certain publicly available financial statements) and that the misrepresentation was material to the insurer's decision to insure the company, whether or not someone at the company was intentionally trying to deceive the insurer or others. Cutter & Buck, applying Washington law, held that the misrepresentation must be made with the intent to deceive the insurer; however, in Washington, the fact that a misrepresentation was made can result in a rebuttable presumption of an intent to deceive.

Financial Errors Also Justify Rescission

Second, the court justified rescission based not on a misstatement or omission in any answer to a question in the application, but rather upon misrepresentations in the company's financial statements that had been reviewed by the insurer in its underwriting process. In both cases, rescission was based on revenue recognition errors in the financial statements-errors that certain board members and officers argued they were unaware of. Nevertheless, because the policy applications were deemed to have incorporated those financials by reference, and because the erroneous financial statements were deemed to be material to the insurer's agreement to insure (if only because an error in the financial statements increases the potential for a suit), rescission was deemed proper as to all insureds.

The courts in both Homestore and Cutter & Buck also held that the fact that the financial statements had not been physically attached to the insurance application was irrelevant. The insured in each case was told that the financial statements would be considered by the insurer in the underwriting process, and that was sufficient to justify rescission.

Ruling Highlights Importance of Careful Consideration Of Insurance Proposals

Finally, these opinions highlight the potential importance of just a few words contained in lengthy insurance contracts. In determining that the insurer could rescind, both opinions relied on the negotiated language of the insurance contract. The key policy provision is severability of the application language. In the context of rescission, the scope of the negotiated severability language will determine whether coverage is available to the innocent insureds. Here, the clarity of the negotiated language is critical. In Cutter & Buck, the innocent insureds thought that the intent of the policy's severability provision was to preserve their coverage, but the legal effect of the chosen words, in that case, proved otherwise.

Of course, severability language is one in a multitude of terms in a D&O policy in addition to moving parts, such as notice, discovery options, and the like). Indeed, there are different types of D&O primary and excess policies on offer, including some that provide coverage for some insureds in the event the primary policy is rescinded.

Insureds are cautioned to work closely with their counsel and broker early in the application and renewal process, to make sure that they are fully aware of the scope and limitations of available coverage.

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