D&O Rescission in the Context of Renewal Policies—What is "Equitable?"

July 01, 2003

Northern California ABTL REPORT, Summer 2003
by Mary McCutcheon

In this challenging economy, Directors & Officers Liability (D&O) insurers are increasingly called upon to respond to securities claims based on restated financials of troubled companies. In cases where those financials were submitted to the insurer as part of the application process, insurers increasingly, and aggressively, attempt to rescind the policy. The insurers argue that it is not "equitable" to require them to honor a contract obtained under false pretences. However, rescission itself may not be "equitable" when the policy is a renewal of a prior policy issued by the same insurer.

D&O policies are "claims-made" policies, providing coverage based on when the claim was asserted, not when the wrongful act which is the basis of the claim was committed. Exceptions to this rule, however, are provided at both the front and back end of the policy. A carrier issuing a new policy usually includes a "retro date" in the policy, which specifies that any act committed before a certain date (often the date of inception of the policy) is excluded from coverage, even if the claim is made during the policy period.

As the policy expires, the insured can take advantage of provisions extending coverage for claims based on acts committed during the expiring policy period which arise at a later date. One provision is an "extended reporting option" which, if the insured or insurer refuses to renew the policy, allows the insured to purchase (for a hefty premium) an additional period in which to report claims based on acts committed during the expired policy period. In addition, D&O policies provide that sufficient notice of a potential liability occurring during the policy which might give rise to a claim at a later date triggers coverage under the expiring policy, even if the claim is asserted afterward. By these provisions, an insured can be reasonably certain that it has continuity of coverage, even if it renews with a different insurer. Moreover, a company who stays with the same insurer has an expectation of continuous coverage, even if an occurrence in one policy period gave rise to a claim in a later period.

Suppose a D&O insurer has insured a high tech or telecom company for several years after a successful IPO. As business slows and the NASDAQ plummets, it is discovered that the sales department has been misstating revenues, causing a restatement of a prior 10 K. The usual securities and derivative actions are filed, and the company declares bankruptcy, leaving directors and officers to defend themselves. They turn to their D&O insurer, only to discover that during the course of the renewal the insurer asked for the 10 K which is now being restated, and now seeks rescission of the policy as to all insureds.

The insurer asserts that it would never have offered coverage for a company if it had known the "true" financial picture of the company when the policy was renewed. It claims, as is required for rescission, that it would be inequitable to force it to bear this risk. In fact, the reverse is true — it would be inequitable to allow it to escape a risk it had already contracted to cover and which, in essence, had accrued under the expiring policy, merely because of a fortuity of timing.

What actually would have happened if the insurer had known the "true" financial condition of the company and refused to renew? (Or raised premiums so that the insured could not renew?) Presumably, the insured would have known the "true" facts as well. It would have purchased the extended reporting option or provided a notice of circumstances, and preserved its coverage when lawsuits ultimately were filed.

When the insurer issued the expiring policy, it accepted the risk of claims for wrongdoing in that period. And, by the discovery period option and notice provisions it accepted the risk of claims made after the policy period which had their origins in events taking place during the policy period.

As a matter of pure contract law, this argument probably fails. Rescission, however, is based not on contract law, but on equity. A court in equity has a great deal of discretion to avoid harsh results that might be mandated under a strictly legal view. See Shapiro v. Sutherland, 64 Cal. App. 4th 1534, 1552 (1998). Rescission is simply a determination that it would be more unfair to enforce the contract than to restore the parties to the status quo immediately prior to the contract. So, not only should a court consider what the insurer would have done "if" it had known the true facts, but also what the insured would have done "if" the true facts had been known: report the risk under the proceeding policy's notice of circumstances provision or purchase a discovery period.

Although none of the reported cases allowing rescission of D&O policies have thus far addressed this issue, when addressing the rescission of a renewal policy, the first question should be: what is really "fair?" It is unfair to allow the insurer to reconstruct the contract with the benefit of 20/20 hindsight without allowing the insured to do the same.