ABA Section of Business Law

Volume 14, Number 4 March/April 2005

So long, D&O coverage
Policy rescission — what the insured can do
    By John C. Tanner

About that D&O coverage: It turns out that later, one person did bad things with the company books. Should all those covered then lose their insurance?

Rescission of director and officer liability insurance is a hot topic in corporate America. Every day, directors and officers read about enormous securities-claim settlements, SEC or other regulatory investigations, and even criminal indictments.

Like you, they saw former Wall Street darlings seemingly go bankrupt overnight, calling into question the security of the indemnification rights granted to directors and officers by their companies. They also watched closely as certain D&O insurance companies rescinded insurance policies in the midst of multi-million dollar securities claims, in some instances, taking coverage away from innocent individual insureds.

Now, perhaps more than ever, individual directors and officers are deeply concerned about their personal financial protection. Every director or officer covered by a D&O policy faces the rescission risk, and all director and officer insureds — particularly those new to corporate service and those who play no direct role in procuring D&O coverage — need to fully understand the issue and its potential ramifications. Despite the increased attention granted the topic, many of your director and officer clients may still be surprised to learn that they may lose coverage under their D&O policy when other insureds supply inaccurate information during the application process.

This article describes D&O policy rescission in general terms, and reviews certain common examples of contract language typically found in traditional primary ("first-layer") D&O liability policies. The article also discusses newer, "nonrescindable" contract wording offered by insurers as a solution to the rescission risk, and explains how the issue may vary even between different insuring agreements in the same policy, or between primary and excess insurers on the same D&O program.

Stripped to its core, insurance rescission is very simple and easy to understand. When a customer tries to buy an insurance policy, he or she provides information to the insurers on which they make their underwriting decision as to whether or not to accept coverage and on what terms or pricing. When, after a loss occurs, the information is later found to be materially false, the insurer can rescind the policy and deny the proceeds.

The issue is perhaps best understood in the context of personal insurance, such as life or health insurance. In underwriting those coverages, insurers frequently assess the insured risk by asking the prospective insureds a number of detailed questions concerning their health. If, despite specific directives in the application, the insured omits to tell the insurer that he or she suffers from a life-threatening or otherwise debilitating disease, the insurer may very well be able to void coverage when it later learns of the insured's true health condition.

Such a result seems intuitively fair when an insured misrepresents information within his or her personal knowledge, particularly when the omitted information is so clearly relevant and material to the insurer's underwriting determination and the ultimate insured risk. Your clients may not fully appreciate, however, that in many jurisdictions, even innocent mistakes in the insurance application process permit an insurer to void coverage to insureds who played no role in completing the application, had no first-hand knowledge as to the alleged misrepresentations, and who honestly believed that the application was true and accurate in all respects.

In the context of D&O insurance, an insurer's ability to rescind coverage as to innocent directors and officers — after a loss occurs — for many individuals calls into question whether the proffered D&O insurance protection is illusory. In a typical case, one or two individuals (often the CEO and CFO) complete the D&O applications and make representations on behalf of all insureds.

Unlike a personal-lines policy, a D&O policy typically provides coverage for numerous insureds including all past, present or future directors and officers, and in the case of securities claims, employees or the company itself may also find coverage. Therefore, in most instances, the D&O insurer relies on representations made by one or two individuals in making its determination whether or not to extend coverage to numerous other insureds.

Similarly, those other insureds assume the benefits of coverage obtained for them by one or two individuals. In the absence of policy language to the contrary, courts have generally held that misrepresentations of the one or two applicants may void coverage for all insureds.

Because, in underwriting the D&O insurance risk, D&O insurers evaluate the same financial statements and information that so often form the basis of D&O claims, the insureds frequently face a policy rescission risk at the very moment the claim arrives. The insurers may seek to void coverage by arguing that the inaccurate financial statements in the underlying D&O claim also fraudulently induced the issuance of the D&O policy itself, or, at a minimum, induced the insurer to offer coverage on terms unreasonably favorable to the insureds.

Your director and officer clients may face this potential rescission risk even where outside professionals certified the accuracy of the corporate financials, and even though they too believed the financials fairly presented the company's condition in all material respects.

Many jurisdictions have statutes that permit a carrier to void a policy on account of innocent but otherwise material misrepresentations in the application. In such states, virtually any accounting restatement or other material accounting error — even if the result of an honest mistake — gives rise to potential rescission of the D&O policy as to all insureds.

Fortunately, there is an emerging trend by the courts treating such statutory provisions as minimum protection that must be afforded insureds, and allowing the parties to negotiate more favorable protection than that provided in the applicable state insurance code.

Current case law suggests that innocent individual insureds may protect against the loss of coverage under these circumstances by negotiating the inclusion of a severability clause into the policy that "severs" the insurer's application defenses and requires the determination of any such defenses separately for each individual insured. The severability wording offered in today's insurance market, however, varies greatly from one policy to the next, and insurers will not always provide the same language for every insured risk.

Most primary D&O policies today include some form of severability clause either in the form itself or by endorsement; however, you should closely scrutinize the specific contract wording in your clients' policies to confirm maximum protection. Some policies contain contract wording with a "severability" label that, in practice, provides little — if any — protection against rescission.

Brokers and other insurance professionals often refer to various severability provisions under two very broad categories. Severability clauses that do not allow an insurer to impute the misrepresentations of one insured to any other insured are generally thought to provide maximum protection against rescission, and are frequently referred to in the industry as providing "full severability."

Severability clauses on the other end of the spectrum that allow imputation in some but not all circumstances are often referred to as "limited severability" provisions. Within each category, numerous variations provide differing levels of protection.

A typical "full severability" provision states that the "application" for insurance "will be construed as a separate application for coverage by each individual insured and that the knowledge of one individual insured will not be imputed to any other individual insured for the purposes of determining if coverage is available." Courts have generally interpreted such "full severability" language as limiting an insurer's right to rescind coverage solely to those individuals who made knowing misrepresentations in the application or who otherwise had knowledge of underlying fraud.

The existence of "full severability" language does not of course prevent an insurer from attempting to rescind the policy; however, with full severability protection, coverage for innocent individual insureds should be preserved. For example, in the case of Healthsouth Corp. (see In re Healthsouth Corp. Ins. Litig., 308 F. Supp. 2d 1253 (N.D. Ala. 2004)), a number of its D&O insurers sought to void all coverage for all insureds in the wake of numerous securities-fraud claims, even though the primary policy contained a full severability provision.

The insurers argued that the policies should be rescinded because they had been issued based on materially false and misleading corporate financial information, and because numerous individual insureds had admitted to fraud or other criminal wrongdoing. Even though the applicable state statute permitted insurers to void coverage on account of innocent but otherwise material misrepresentations, the district court interpreted a full severability clause in one of Healthsouth's primary policies as modifying the statutory protection to require proof of knowing misrepresentations attributable to each insured for which the carriers sought to void coverage. In light of the district court's interpretation, Healthsouth insurers with full severability wording have thus far been unable to void coverage as to individual insureds.

During the hardening D&O insurance market of the last couple years, many D&O insurers replaced "full severability" provisions in their forms with "limited severability" provisions that impute the knowledge of the application signers to all insureds, but otherwise purport to provide full severability. A fairly typical "limited severability" provision provides that "no knowledge or information possessed by any individual insured will be imputed to any other individual insured except for material facts or information known to the persons who signed the application."

The exception in such wording, of course, makes clear that the insurer may still void coverage even as to innocent insureds where any individual signing the application had knowledge of the fraud. Because most D&O insurers require that the CEO and CFO sign the applications, the applicant is often the very individual most likely to have knowledge of aggressive accounting decisions or outright accounting fraud on the part of the company.

Indeed, the Sarbanes-Oxley Act of 2002 now imposes a requirement that such officers certify that publicly disclosed corporate financials are fairly presented and that the company maintains disclosure controls and procedures to ensure that material information is brought to their attention.

The recent rescission case of Cutter & Buck Inc. v. Genesis Ins. Co., 306 F. Supp. 2d 988 (W.D. Wash. 2004) provides a good example of how "limited severability" provisions may, at least in some circumstances, provide more limited protection than your clients realize. There, the district court allowed complete rescission of Cutter & Buck's D&O policy as to all insureds even though the policy included a "limited severability" clause, and even though the applicable state law required proof of fraudulent intent as a prerequisite to rescission.

An investigation into various alleged revenue-recognition schemes revealed that Cutter & Buck's former CFO — who signed the application for D&O insurance — had prior knowledge concerning certain fraudulent accounting transactions. Because the application signer had fraudulently misrepresented material information to the D&O insurer, numerous "innocent" directors and officers named as defendants in resulting lawsuits lost coverage.

From a new board member's perspective, limited severability language therefore ties the rescission risk to the honesty and judgment of one or two individuals signing the application, even under circumstances where those individuals are no longer affiliated with the company.

The Healthsouth and Cutter & Buck cases involved severability provisions in traditional D&O policies affording coverage for both indemnifiable and nonindemnifiable claims. Coverage under a traditional D&O policy is typically divided into three coverage parts.

Coverage under "Side A" (referred to as Insuring Clause 1 in some policies) provides coverage for "nonindemnifiable" claims where the company is legally or financially unable to indemnify the individual insured defendants. For example, under certain state laws, a company might not be legally permitted to indemnify its directors and officers against settlements or judgments in derivative cases. Another example is the SEC's long-standing position that indemnification for actual securities law violations violates public policy. A company might also simply face a cash shortage and be unable to fund the indemnity.

Most D&O claims, however, including defending against derivative cases, and both defending and settling shareholder class action claims, are generally considered indemnifiable and fall under "Side B" coverage in a traditional D&O policy. Coverage under "Side B" (or Insuring Clause 2 in some policies) provides reimbursement to the company to the extent it indemnifies individual directors and officers, usually in excess of a fairly large deductible. Finally, many traditional D&O policies also include "Side C" coverage that provides direct coverage to the entity itself for securities claims, also subject to the deductible.

Because most D&O claims are indemnifiable, D&O insurers are more willing to provide full severability protection in a nonindemnifiable "Side A" claim context than in the indemnifiable claim context of the traditional "Side B" corporate reimbursement coverage or "Side C" entity coverage. Some insurers have even gone so far as to expressly waive their right to rescind "Side A" coverage for individual insureds, either in a separate "Side A" only excess insurance product specifically devoted to individual insureds, or as a carve-back to a limited severability clause in the traditional D&O policy that expressly provides that the insurer will not rescind coverage for nonindemnifiable claims.

Because primary policies provide the first line of defense against D&O claims, negotiation of severability wording in the primary policy receives the greatest attention. However, the rescission risk in excess policies should not be overlooked. Even where insureds have successfully negotiated favorable severability protection in their primary D&O policies, the insureds should not assume that the excess insurers would recognize or apply the same favorable language to the excess insurance layers.

There is a common misconception that excess policies always follow the coverage terms of the primary policy. While most excess D&O policies are "follow-form" of the primary lead policy, excess policies typically state that they follow the terms and conditions of the followed primary policy, unless and to the extent that the excess form, or other excess forms beneath its attachment point, contain more restrictive coverage terms.

To the extent that the excess policy contains its own severability wording or other policy language concerning the application process, those excess insurers may argue that their policies contain more restrictive severability wording than any underlying insurance.

In the Worldcom litigation, for example, the excess insurers continue to seek rescission as to all insureds notwithstanding the fact that the underlying primary insurer has paid its coverage in full on behalf of the individual defendants (See In re Worldcom Inc. Sec. Litig., No. 02 Civ. 3288 (DLC), 2004 WL 2955237 (S.D. N.Y. Dec. 22, 2004)). Excess insurers in the Healthsouth and Xerox securities litigation have also advanced positions that are inconsistent with the severability wording contained in the applicable primary policy (See In re Healthsouth Corp. Sec. Litig., supra; National Union Fire Ins. Co. v. Xerox Corp., No. 603360/03, 2004 WL 2715603 (N.Y. Sup. Nov. 10, 2004)).

Many excess insurers now routinely request that insureds agree to "reliance" or warranty endorsements in lieu of submitting separate applications to the excess insurer. The stated justification for such endorsements is the need to document the excess insurer's underwriting decision in reliance on the representations and statements provided by the insureds to the primary insurer.

Insurance underwriters often suggest that a "reliance endorsement" is standard language required in lieu of submitting a separate application to the excess insurer. Unfortunately, most such endorsements go beyond merely stating that the excess insurer has relied on the statements and representations contained in the primary D&O policy application.

Some such endorsements provide that the insureds further represent and warrant the accuracy of all public filings. Other variations even expressly substitute representations and severability language for that provided in the primary policy.

In other cases, excess insurers may include an endorsement that simply restates the controlling state law concerning the minimum protection against rescission that must be provided to that state's insureds. Where such an endorsement — frequently referred to as a "state amendatory" endorsement — is added to the D&O policy, insureds may lose any "full severability" protection previously negotiated into the policy. Unless "full severability" protection is subsequently endorsed on to the policy, the amendatory endorsement may have the effect of reinstating the applicable state's minimum requirements.

Insureds should accordingly obtain clarification that excess insurers in their D&O program follow the most favorable severability protection negotiated at the primary layer. Otherwise, such endorsements may permit excess insurers to rescind coverage even under circumstances where the primary insurer is unable to do so.

In the current claim environment, it is imperative that you protect your director and officer clients against rescission risk:

• Emphasize the importance of protecting against the rescission risk early in the underwriting negotiations. Last-minute requests for full severability are more likely to be denied by D&O underwriters.
  
  
• Seek "full severability" or "nonrescission" wording in the traditional D&O policy. By preserving full severability protection for all indemnifiable claims, companies should have at least some insurance coverage available to fund the defense of "innocent" insureds, as well as to contribute toward settlement of claims brought against such insureds.
  
  
• Where "full severability" or "nonrescission" wording for indemnifiable claims is unavailable, request that the traditional D&O policy include a provision waiving the insurer's right to rescind coverage for nonindemnifiable claims.
  
  
• Make Side A-only excess coverage a part of your D&O program. Side A-only excess policies typically provide broader coverage terms than those contained in traditional D&O primary policies, including provisions expressly stating that the policies are "nonrescindable." Where the traditional D&O policy contains no severability provision, limited severability for all coverage, or the insurer refuses to waive its rescission right for nonindemnifiable claims, a Side A-only excess policy can protect your individual clients against rescission and do so with the added benefit of broader coverage terms.
  
  
• Finally, do not ignore the excess policies. Excess insurers are now routinely arguing that their policies do not "follow form" over the primary policy's severability wording. Your clients should confirm, early in the underwriting negotiations, that their excess carriers follow any favorable severability language negotiated at the primary layer.