Project: Corporate Counsel - Law Firms Directors And Officers Beware: Will Your Company's D&O Insurance Policy Be There When You Need It Most?

Sunday, May 1, 2005 - 00:00

Imagine the following nightmare scenario: You are an officer or director of a publicly-traded company.The company's finance department discovers serious errors in the financial statements reported in the company's last 10-K or proxy statement.The company does the right thing, corrects the errors and announces the corrections to the investing public and the Securities and Exchange Commission.The market reaction is swift and severe:the company's stock price drops by 20 percent.Soon after, the first class action and derivative suits are filed, triggering a slew of litigation.The plaintiffs name you along with other directors and officers personally as defendants.The company notifies its directors and officers liability insurance carrier of the claim, and requests indemnity and reimbursement of defense costs for you and the other defendants.After all, this is why the company bought the D&O policy and paid all those premiums.Yet, rather than agree to cover the claim, the insurance carrier tells you the policy is void because the company "defrauded" the carrier, and that the carrier intends to "rescind" it.Either you or, if you are lucky and the company is not bankrupt, the company will have to fund your defense with no assistance from the carrier.

The above scenario is becoming an all-too-frequent reality for companies - and their directors and officers - who find themselves defendants in securities fraud and shareholder derivative suits.As the recent notorious securities fraud scandals at Enron, Worldcom and other companies have begun to generate billion-dollar settlements and judgments, D&O carriers are becoming increasingly more aggressive in their attempts to avoid their coverage obligations.Employing a tactic historically used (with considerable success) by the life insurance industry, D&O carriers now frequently argue that they are entitled to rescind their policies because the insured company concealed from the carrier - either on its initial application or at renewal - facts which were likely to lead to securities fraud claims against the insured during the policy period. The insurance company, so the argument goes, is as much a victim of the underlying misrepresentations as the plaintiff investors, and consequently should not have to pay for risks it did not knowingly and voluntarily choose to underwrite.

All is not lost, however.As the law continues to develop in this area, there are two things an insured can do to help protect itself.First, insureds can negotiate for the inclusion of a "severability" clause in the policy.A severability clause limits the carrier's ability to impute one insured's knowledge of malfeasance to all persons covered under the policy, so that, for example, the members of the company's board of directors need not forfeit coverage merely because the chief operating officer concealed from everyone ongoing efforts to artificially inflate company's revenues. Second, insureds need not give up on their claim merely because the insurance company announces its intention to rescind the policy. Often the policy - and the courts - will impose continuing duties on the carrier to reimburse the insureds' defense costs until a judicial resolution of the carrier's purported right to rescind the policy is reached.

Rescission Generally

Unlike cancellation, which operates prospectively, rescission extinguishes all of the insurers' obligations to the insureds, and the contract is considered never to have existed.Like any other contract, an insurance contract can be voided if it was induced by fraud.In the context of D&O policies, the fraudulent - or, in some cases, negligent - statement generally arises one of two ways.First, the alleged misstatement may be one of subjective fact.D&O applications usually require prospective insureds to disclose whether they know of any facts or circumstances which may give rise to a claim in the future.The insured's failure to disclose such known facts may provide the insurer with grounds to rescind coverage.Second, the misstatement may consist of an objective fact.Insurers often require that a company agree to submit financial statements and SEC filings during the application process, which are ultimately incorporated as part of the D&O policy.These documents may form the basis of a rescission action.In the typical accounting fraud case, someone at the company is nearly universally alleged to have "cooked the books" and caused some or all of the company's publicly filed documents to be false or materially misleading.Irrespective of whether the misstatement in question is classified as subjective or objective, if proved, the insurer may succeed in rescinding the policy.

The outcome of an action for rescission is highly dependent on the facts of the given case, particularly the language of the policy at issue, and the state law requirements for rescinding an insurance contract.Consequently, rescission cases often involve unique facts and divergent law.Despite these differences, a few common elements can be gleaned from these cases.Although state law governs the requirements needed to effect rescission of an insurance contract, most states require that the insurers refund all of the premiums paid under the policies at that time of the rescission.In addition, states generally require that the insurer demonstrate that one or more of the insureds made a misstatement or omission of material fact in connection with the application for insurance and that the insurer relied on such a misstatement or omission.In a minority of states, the insurer must also prove that the insured acted with an intent to deceive.

Rescission can be a harsh remedy, especially where certain officers and directors clearly took no part in the misstatements that triggered the rescission.Indeed, rescission usually leaves all of the formerly insured individuals without coverage, even those who did not participate in and had no knowledge of any wrongdoing.Accordingly, courts remain mindful of the tension that exists between stripping an innocent person of D&O coverage and imposing on an insurer a duty to which it never agreed: "Whichever way a court rules on this question, it will cause hardship to an innocent party: either the innocent insureds who did not make any misrepresentation, or the innocent insurance company which was deceived." Mazur v. Gaudet, 826 F. Supp. 188, 195 (E.D. La. 1992).However, so long as the insurer can prove that it relied on a misstatement or omission of material fact, the insurer will usually prevail in rescinding the policy as to all of the insureds, regardless of the innocence of some of them.To avoid this result, companies should attempt to negotiate for, and their officers and directors should insist on, the inclusion of a severability clause in any D&O policy.

Pre-Litigation Planning:Severability Clauses

Severability clauses are either "full" or "limited."A full severability clause provides that the parties deem the application a separate application for coverage by each of the insureds and/or that no statement in the application or knowledge possessed by one insured shall be imputed to any other insured.As its name suggests, a limited severability clause is more narrow.It provides that no knowledge possessed by any insured shall be imputed to any other insured, except for material information known to specifically designated individuals who signed the application.Recently, the insurance industry has also placed limits on the "limited" severability clause such that if certain executives have knowledge, then coverage for the company, and possibly all insureds, may be lost.

A severability clause, however, is no panacea.Depending on the language of the policy, even a full severability clause may not preclude an "innocent" insured from losing coverage.For example, most states permit rescission of the policy if the insurer relied on a negligent, but material misrepresentation.In such cases, the insured's subjective knowledge of the misstatement is irrelevant, and rescission is proper despite the presence of a severability clause that prohibits the imputation of one insured's knowledge to another insured. However, even in jurisdictions that permit rescission on the basis of a negligent misrepresentation, the insurer may waive the ability to proceed on a negligent misrepresentation theory if the policy refers only to intentionalmisrepresentations.

Accordingly, when your company's D&O policy comes up for renewal this year, review the contract to ensure that it contains the broadest severability clause the market will offer.The inclusion of such a clause is the best protection against an insurer's attempt to rescind the policy for fraud.

Securities Fraud And D&OPolicy Litigation Issues

Over the past few years, numerous insurance carriers have attempted to rescind the D&O policies of officers and directors in some of the country's most high-profile securities fraud cases.Corporate counsel should remain mindful of a common theme that can be gleaned from these cases:An insurer's notice that it has rescinded a D&O policy for fraud need not - indeed, should not - be taken at face value.In several recent decisions, the courts have made it clear that notwithstanding an insurer's attempt to rescind a D&O policy, the insureds still have rights under the policy, and they should fight to keep them.In addition, these courts have clarified several important issues relating to the validity and interpretation of rescission provisions in D&O policies:

  • Must an insurance carrier pay defense costs while an action to rescind the policy is pending? Yes, "where an insured has challenged the right of an insurer to rescind its policies and has sought an adjudication that the policies are binding, courts have enforced the obligation of the insurers to perform under the policies and to defend or to pay defense costs." In re WorldCom, Inc. Sec. Litig., 354 F. Supp. 2d 455, 465 (S.D.N.Y. 2005); see also Fed. Ins. CO. v. Tyco Int'l Ltd., 2 Misc. 3d 1006, 784 N.Y.S.2d 920, 2004 N.Y. Misc. LEXIS 228, at *17 (N.Y. Sup. 2004) (holding that the carrier's "unproven rescission claim does not affect its present obligation to defend [the insured] or pay his defense costs under the Policies."). However, it is important to note that if the insurers' rescission action is successful, the insureds may be required to return any defense costs advanced by the insurer.
  • Can an insurance carrier unilaterally rescind a policy without judicial intervention?Several courts have said no.In the most recent of these cases, Judge Cote of the Southern District of New York noted that, "[u]ntil the issue of rescission is adjudicated, a contract of insurance remains in effect. . . ." WorldCom, 354 F. Supp. 2d at 465.In fact, one court went so far as to say that "[i]nsurance carriers do not function as courts of law.If a carrier wants the unilateral right to refuse a payment called for in the policy, the policy should clearly state that right.This policy does not do so." Associated Electric & Gas Ins. Servs., Ltd. v. Rigas, No. 02-7444, 2004 U.S. Dist. LEXIS 4498, at *44-45 (E.D. Pa. Mar. 17, 2004).
  • Can an insurer seek rescission of a D&O policy based on misstatements in a company's financial statement or SEC filings?It depends.If the insurer merely requires that the applicant "attach" various documents to the application, it is unlikely that the misstatements in such documents will support rescinding the policy, although the ultimate outcome will hinge on the law of the particular state. See Cutter & Buck, Inc. v. Genesis Ins. Co., 306 F. Supp. 2d 988, 999 (W.D. Wash. 2004) (citing National Union Fire Ins. v. Cont'l Ill. Corp., 643 F. Supp. 1434 (N.D. Ill. 1986)).On the other hand, however, if the application incorporates these documents and requires that the applicant attest to their truth, a material misstatement in one of the documents might provide the insurer with sufficient grounds to seek rescission of the policy. Id . at 998-99.This is another issue to be aware of when the terms of the policy are negotiated.
  • If rescission acts to void the contract, is the severability clause void as well?This precise issue arose in In re HealthSouth Corp. Ins. Litig., 308 F. Supp. 2d 1253 (N.D. Ala. 2004).In that case, the severability clause in the primary policy stated that "no statement in the application or knowledge possessed by any Insured Person shall be imputed to any other Insured Person for the purpose of determining if coverage is available." Id.at 1261.Nevertheless, 10 insurance carriers sought to rescind coverage under the D&O policies.Some of the carriers contended that the severability clause never became effective, and therefore protected no one, because the alleged misrepresentations rendered the policy void from its inception. The Court rejected this argument, noting that "[i]f the companies can rescind coverage because of misstatements or misleading statements in HealthSouth SEC filings, without showing that the individual knewof the misstatement, then coverage under the D&O policies would be illusory. . . . Such an interpretation would violate the manifest intent of the policy, and would ignore the motivation for obtaining officers and directors coverage in the first place - to protect officers and directors from liability for actions of the corporation."Put simply, a severability clause means what it says, and a carrier cannot obtain rescission without satisfying the requirements set forth in that provision.

Conclusion

Given the recent flurry of attempts by insurers to rescind D&O policies in the context of securities fraud actions, officers, directors and their general counsel should ensure that their risk managers and insurance brokers (i) are aware of the issues, (ii) do not simply accept the carrier's "off the shelf" product, and (iii) negotiate policy language that is as favorable to the insured as possible. Including a well-drafted severability clause and other protections in D&O policies may help to ensure that your officers and directors will retain their coverage when they need it most. Similarly, taking an aggressive posture with the carrier when the claim is tendered may help to minimize the negative financial consequences if the carrier tries to rescind.

Linda A. Bennett is a Member of the Litigation Department and Insurance Law Practice Group of Lowenstein Sandler PC, based in Roseland, New Jersey. She can be reached at (973) 597-2386. William M. Uptegroveis an Associate in the firm's Litigation Department and a member of its Securities Litigation and Enforcement Practice Group. He can be reached at (973) 422-6424.

Please email the authors at lbennett@lowenstein.com and wuptegrove@lowenstein.com with questions about this article.