Tenth Circuit Takes a Look at D & O Policy Rescission

In a July 25, 2007 opinion (here), the Tenth Circuit examined whether misrepresentations in financial statements incorporated by reference in a D & O policy application could serve as a basis for policy rescission under Utah law.

The case involved a D & O policy issued to ClearOne Communications in 2002. In early 2003, ClearOne issued a press release stating that its financial statements from the preceding two years should not be relied upon, in part because the company had discovered that the company had entered distributor agreements that had the effect of accelerating revenue recognition. This disclosure triggered shareholder lawsuits (refer here), for which the company sought coverage under the D & O policy. The D & O carrier sought to rescind the 2002 policy based on the financial misstatements, which the carrier contended had been incorporated by reference in the policy application. ClearOne and one of its directors sued the carrier, seeking to enforce their rights under the D & O policy. The District Court held that the carrier had properly rescinded the policy.

On appeal, the Tenth Circuit made a number of findings. The Tenth Circuit found first that Utah law did not prohibit incorporating the financial statements into the application by reference; second, that the District Court did not err in finding that there was a sufficient misstatement to establish rescission, if the other elements were met; third, under Utah law, a misrepresentation occurs if the applicant knows or should have known about a misstatement in the application and still presents it to the insurer; and fourth, that the record was unclear whether the official that completed the application "should have known" about the financial misstatements, and so the Tenth Circuit remanded the case back to the District Court on this question.

The Court went on to construe the "severability" clause in the policy, which limits the imputation to other insureds of knowledge of misstatements, and so potentially preserves coverage for insureds who were unaware of the misstatements. The severability language in the ClearOne policy was limited by the language in the relevant section's preamble that restricted nonimputation to the "questions 8, 9 and 10" in the application. Since the insurer's rescission claim was based on answers and information provided in response to question 14, rather than on questions 8,9 or 10, "the severability clause does not cover ClearOne's misstatement and it would be ineffective against [the carrier's] rescission of the insurance policy in its entirety should the financials be deemed to be a non-innocent misrepresentation."

This Tenth Circuit's discussion of the severability issue is an important reminder of the potential significance of seemingly subtle differences in policy language. If the ClearOne severability language had been broader and not restricted to the specific application questions, then there would be a possibility that coverage might be preserved for innocent insureds even if the carrier were otherwise able to establish grounds for rescission. The marketplace has evolved significantly since the ClearOne policy was placed in 2002, so it is hardly fair to judge the language in that policy by today's standards. But there is no doubt that in the current marketplace it is possible to obtain severability language that provides more comprehensive and less restricted nonimputation protection for innocent insureds. In addition, a complete management liability insurance program today would also include a Side A/DIC policy intended to protect the directors and officers in the event that the traditional D & O policy were to be rescinded. These considerations collectively represent another example of the importance of involving knowledgeable insurance professionals in the D & O insurance acquisition process.

For a good summary of the issues surrounding the severability clause in D & O policies, refer to this article (here) by noted D & O commentator Dan Bailey.

Special thanks to Dan Standish of the Wiley Rein law firm for forwarding a link to the 10th Circuit opinion in the ClearOne case.

Climate Change and Board Duties: In earlier posts (most recently here), I have examined the increasing D & O risk arising from global climate change liability exposures. A July 24, 2006 Law.com article entitled "Boardroom Climate Change" (here) written by Jeffrey Smith and Matthew Morreale of the Cravath law firm takes a closer look at board room risks arising from global climate change and examines the ways in which climate change decision-making will "test the limits and scope of fiduciary duties of officers and directors as their responses to matters relating to climate change are questioned by stakeholders."

The authors identify "five new phenomena" that "pose new challenges for directors overseeing climate change decision-making": 1) uncertain and fragmented environmental legislation and regulation; 2) the reactions of capital and insurance markets to emerging climate change business opportunities; 3) increasing stakeholder activism; 4) pending litigation; and 5) the rapidly evolving scientific debate.

The authors contend that these factors have "added a new dimension to management’s obligation to monitor corporate performance and make informed decisions in light of all reasonably available material information." The article concludes by noting that:

To the extent that a company’s response to climate change becomes a proxy for both smart management and corporate stewardship, directors have an incentive to be increasingly vigilant in assuring that management has maximized economic opportunity, reduced economic risk and preserved corporate reputation.

As I have previously noted, these changing circumstances not only provide opportunities for "smart management and corporate stewardship"; they also provide a context within which it is prudent to assume that claims will arise, alleging that boards failed to exhibit appropriate management and stewardship. For that reason, boards must anticipate that "stakeholders" increasingly will demand action and information surrounding climate change issues. Companies should also anticipate that D & O underwriters increasingly will inspect companies’ climate change related disclosures and actions. By the same token, D & O insurance policy wordings, particularly the pollution and the bodily injury/property damage exclusions, and program structure, including the incorporation of appropriate Side A/DIC protection, will be increasingly important parts of corporate risk management, in light of increasing potential exposures arising from global climate change.

A good summary of the climate change-related D & O policy wording issues can be found in this recent article (here) by my good friend Joe Monteleone. Joe and I will be among the panelists speaking in a Mealey's teleconference on D & O Litigation Topics on August 15, 2007 (refer here), including, among other things, issues pertaining to global climate change.

Hat tip to the SOX First blog (here) for the link to the Law.com article.

"Exploding" FCPA Enforcement Activity: In earlier posts (most recently here), I have addressed the growing corporate exposure arising from antibribery enforcement. The significance of these issues was underscored in a July 25, 2007 memorandum from the Gibson, Dunn & Crutcher law firm entitled "The FCPA Enforcement Explosion Continues" (here).
According to the memorandum, the law firm has identified "approximately 100 companies" that currently have open Foreign Corrupt Practices Act (FCPA) investigations. The memorandum’s authors also state that they "expect U.S. authorities to initiate an increasing number of enforcement actions in the next few years and to seek more severe penalties for FCPA violators."

This growing FCPA enforcement threat was demonstrated just this week, with the news, according to the July 25, 2007 Wall Street Journal (here), that the Department of Justice is conducting a criminal investigation involving nearly a dozen oil and oil services companies focusing on illegal payments to customs agents in Nigeria, Kazakhstan, and Saudi Arabia.

In earlier posts (refer here), I have noted that the D & O risk associated with FCPA enforcement actions arises not so much from the FCPA enforcement action itself, but from the threat of follow-on civil claims brought by shareholders and based on the improper activity or associated disclosures. The Gibson Dunn memorandum, referring to the same cases I have previously cited, expressly notes the growing threat of FCPA-related follow-on civil litigation and states that "in the current environment of heightened scrutiny" these kinds of claims "may start to gain traction.’ The memorandum further emphasizes that "one thing is clear: the legal road towards resolving an FCPA violation in the U.S. now stretches far beyond achieving peace with the DOJ and the SEC."

Away Message: The D & O Diary's publication schedule will slow down for the next few days. I will resume my "normal" schedule after August 6.