Restatement Does Not Equal Rescission

April 10, 2002

by Mary McCutcheon

It is never easy to convince Directors & Officers (D&O) Liability insurers to contribute significant amounts to securities class action settlements. The assumption that the insurer would at the very least play a major role in settlement, however, has been shaken by the insurance industry's recent propensity to seek rescission in the face of securities claims based on restatements of earnings or other financial improprieties.

D&O insurers claim they issue a policy in reliance upon the company's financial statements, which generally are provided to the insurer when the policy is issued or renewed and are often incorporated into the policy application. So, when the financials are restated (and the class actions are filed), the insurers contend that the application incorporated a material misrepresentation (the earnings as set forth in the financial statement), and therefore the insurer is entitled to rescission. In other words, the very event which triggers the insured's need for D&O coverage—the restatement—eliminates that coverage.

What To Do When Buying A Policy
There are some minor, but critical, policy features which might avoid a rescission claim altogether, or at least strengthen the policyholder's chance of prevailing against such a claim. Companies evaluating their D&O Liability Insurance options should be aware of what information the insurer is requesting and purporting to rely on in the application process. They should be extremely careful as to the form of warranties or representations executed by any officers or directors in connection with the application, whether concerning financial statements or knowledge regarding any potential claim (another ground for rescission).

Some policies provide that if there is a misstatement in the application or accompanying financial statement, the insurer will seek rescission only as to those insureds either responsible for or having knowledge of the misstatement. Policies silent on this point, however, maintain the right to seek rescission against all directors and officers, no matter how "innocent," and should be avoided if possible.

Another common policy feature, although not expressly addressing rescission, provides a strategic advantage to the insurer—the arbitration clause. While arbitration might offer a speedier resolution of the dispute, an insurer is more likely to pursue a rescission claim, or simply cite rescission as grounds for denying coverage, if it need not face a jury's outrage. Again, avoid such provisions if possible.

What To Do When The Insurer Rescinds
Assuming the first time you review the D&O policy is after the restatement has been issued and the class action has been filed, all is not lost. The carrier is entitled to rescission only when, in issuing the policy, it has relied on a material representation which was not true when made. While at first glance a restatement seems to satisfy that criteria automatically, such is not always the case.

The Representation: In some instances the financial statements are not made a part of the application, and therefore do not constitute a representation to the insurer. This may be particularly true in a renewal situation, where the insurer and company have an ongoing relationship and renewal is almost automatic.

Materiality: In some instances, the restated earnings may not be material from an insurer's perspective. Particularly in a renewal situation, the fact that earnings per share might be ten cents less than originally promised probably would not influence the insurer's decision to underwrite the policy. This argument has particular appeal in a competitive D&O market (which has existed over recent years). Keep in mind, however, that many jurisdictions consider financial information material by definition, especially if the insurer requested it.

Falsity: An auditor may require restatement not because of a change in financial condition, but because of a change in accounting policies. While the financial statement might have been true at the time it was made, retroactive imposition of a new accounting policy forces a restatement. Therefore, the initial financial statement was not false under the accounting policies in place at the time the financial statement was issued. This argument might also prove successful where the restated financials were interim 10Q statements, and not the year-end 10K.

Knowledge: In many states, it is unclear to what degree rescission depends on the insured's state of mind. In California, for example, courts hold that rescission is available regardless of the intent to deceive, but modify this apparently strict liability standard by holding that rescission is not available if the insured did not realize that the information supplied was false—a fine distinction, but an important one. See Miller v. Republic National Life, 789 F.2d 1336 (9th Cir. 1986). See also Old Republic Ins. Co. v. Rexene Corp., 1990 Del Ch. Lexis 187 (Del. Ch. Nov. 5, 1990) (comparing Delaware law, which requires knowledge of the falsity, with Texas Law, which requires intent to deceive).

So don't assume that restatement equals rescission.