Independent directors and officers, who may have once been secure in believing they were covered for most categories of potential professional liability through their directors and officers (d&o) insurance coverage absent personal malfeasance, may now have serious reason for concern. Two recent decisions from the Ninth Circuit Court of Appeals have held that material misrepresentations known to a director or officer who signed the insurance application can be imputed to innocent directors and officers, thus enabling the insurance provider to rescind coverage for all (regardless of personal culpability).
In Cutter & Buck (C&B) v. Genesis Insurance Company (Genesis), the Ninth Circuit reviewed and interpreted a d&o liability insurance policy. The policy contained "limited severability" clauses permitting the insurer to rescind coverage for all directors and officers, including those who did not have personal knowledge of any material misrepresentations made in the application for coverage. The Ninth Circuit upheld a ruling from the District Court for the Western District of Washington that "material misrepresentations known to the director or officer who signed the application can be imputed to innocent directors and officers."
In Cutter, the chief financial officer manipulated sales information to increase revenue. The application for the d&o insurance policy contained a revenue recognition provision and required the applicant to verify that the statements in the application were true. Further, the policy required additional information, such as C&B’s annual report and its U.S. Securities and Exchange Commission (SEC) filings. In the case, the district court held that a representation made in conjunction with an insurance application is material if the additional information influenced the insurance company’s decision to issue the coverage. As a result, this holding could be used by subsequent courts to deny coverage for innocent directors and officers if an applicant submits incorrect or fraudulent material to an insurer.
In Federal Insurance Company (Insurers) v. Homestore, Inc. (Homestore), the Ninth Circuit Court of Appeals affirmed a ruling from the District Court for the Central District of California permitting the insurance company to rescind the d&o insurance policy for all directors and officers. Homestore submitted a renewal application for d&o liability insurance that contained a provision stating all materials submitted with the policy were deemed material and the policy was being issued assuming the truth of such submitted materials. Homestore’s then chief financial officer (CFO), who signed the policy, was subsequently charged with securities fraud and pleaded guilty to overstating Homestore’s advertising revenue and filing false quarterly reports with the SEC. The district court held that based upon the plain language of the contract, the CFO made material misrepresentations under the policy by virtue of the misrepresentations contained in Homestore’s quarterly reports. The district court further found the contract "unambiguously provided that the Insurers could rescind coverage ‘as to all Insureds’ if one or more individual signing the application had knowledge of material misrepresentations in the application." Importantly, the court noted that the stated language of the policy of "one or more" indicated that the number of insureds affected by a knowing misrepresentation of a single insured would be imputed to all insureds.
These cases illustrate the need for independent directors and officers to require their own counsel to review the charter, bylaws, and any indemnification and contribution agreements to which they are a party. In cases where corporate charters and bylaws provide officers and directors indemnification to the fullest extent permitted by law, indemnification and contribution agreements may not necessarily expand the scope of indemnification and contribution but may provide additional safeguards to independent directors and officers.
Additionally, independent directors and officers are well advised to become involved (or to involve their own counsel) in coverage negotiations with their d&o policy carriers in order to secure more favorable policy terms regarding separate treatment of different classes of insureds and the imputation of knowledge from one insured to another. We have found that these provisions are not "boilerplate" and are in fact negotiable. Once pressed, many insurers agree to favorable separation of insured and imputation provisions and to manuscript such terms in a manner favorable to independent directors and officers.
It should also be noted that because these policies are almost always claims-made-and-reported, one-year policies, independent directors and officers should not consider themselves stuck with old, unhelpful policy language and can, in fact, effect meaningful changes with respect to policy renewals.
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