Court Rejects D & O Insurer’s Attempted Policy Rescission

In a September 21, 2007 opinion (here), issued following an earlier bench trial, United States District Judge Charles A. Pannell, applying Georgia law, rejected AFC Enterprises’ D & O carrier’s attempt to rescind AFC’s D & O policy and ordered the carrier to pay over $24 million in compensatory damages and prejudgment interest. AFC’s September 26, 2007 news release announcing the decision can be found here.

Judge Pannell essentially held that the carrier was obligated to pay its full $20 million policy limits (plus interest) to cover amounts AFC incurred in defense and settlement of the consolidated shareholder litigation that followed the company’s March 24, 2003 announcement that it would be restating its financial statements for 2001 and the first three quarters of 2002. The March 24 announcement came just three weeks after the inception date of the company’s renewal D & O policy.

In seeking to rescind the policy, the carrier relied on statements made on the company’s behalf at a January 24, 2003 renewal meeting and in the company’s renewal application, which the company’s CEO signed and dated on February 20, 2003. The carrier bound the renewal coverage on February 28, 2003, and the renewal policy incepted on March 2, 2003, for a one-year policy term ending on March 2, 2004. The policy had a $10 million D & O limit, and a separate $10 million limit for offering underwriter coverage. The parties to the coverage case stipulated that by virtue of the dual limits, the policy provided a maximum of $20 million in aggregate limits (although, as noted below, an odd issue arose following trial on the question of the amount of limits available).

Essentially, the carrier took the position that the AFC knew but failed to disclose to the carrier at the January 24 renewal meeting and in the February 20 application that it would be restating its financials, and in any event that the company had a duty to update the application information when it became apparent to the company that it would be restating its financials.

The company’s auditor had been Arthur Anderson, but due to that firm’s legal woes following the Enron scandal, the company retained KPMG as its auditor in early 2002. The trial testimony showed that roughly at the same time as the underwriting process was unfolding, the company was going through its year-end audit for the first time with its new auditor. An issue arose during the audit regarding the method the company used to account for the impairment of long-lived assets. The company had previously used a "market-based" approach to evaluate its impairments; but in late 2001, the Financial Accounting Standards Board issued FAS 144, which KPMG contended required that long-lived assets be grouped together at an individual store level rather than on a market-wide basis. The company’s CFO and KPMG were in disagreement on this issue. The trial testimony showed that the FAS 144 question was an issue throughout the audit, but the court found that a decision had not been reached on the question until a series of meetings whose timing ultimately proved to be critical to the outcome of the rescission cases.

The minutes of the company’s audit committee’s February 28, 2003 meeting showed that the FAS 144 questions "were delaying completion of the audit" but that "no decision was reached on the resolution of those issues at the meeting." On March 1, 2003, a group of company officials met to discuss the status of the audit. The court found that at the meeting, company officials were "confused and frustrated" at KPMG’s position. In this March 1 meeting, the court found, "the subject of a possible restatement of AFC’s financial statements for 2001 and the first three quarters of 2002 was first discussed, because a restatement might be necessary to ensure a consistent presentation of earnings if a new methodology was adopted." The company’s President later that same day learned of the possible restatement "but no decision was made at that time."

On March 3, 2003, the company’s CFO recommended to the audit committee that the company re-audit and restate the prior financial statements, which recommendation the audit committee approved on March 10, 2003. On March 24, 2003, the company announced that it would be restating the prior financial statements. Almost immediately, a number of securities class action lawsuits and shareholders’ derivative lawsuits were filed. (A description of the shareholder class action lawsuit can be found here. The Third Amended Class Action Complaint can be found here.) The named defendants in the shareholder suits included both the company and its directors and officers as well as the company’s offering underwriters. On August 24, 2004, the company announced that it had rescinded the policy.

The company ultimately settled the consolidated shareholder lawsuits and derivative lawsuits for a total of $16.7 million, with an added agreement to pay 60% of any amount recovered against AFC’s insurers, up to a maximum of $6 million. The company also spent a total of $8.7 million defending the cases.

The carrier filed a declaratory judgment action against the company and its directors and officers, and the company counterclaimed for breach of contract and bad faith.

In the coverage case, Judge Pannell found that the carrier did not carry its burden of showing a misrepresentation in the February 20, 2003 application. The court found that the company’s CEO "had very little knowledge about the technical audit issues" until he was told about the possibility of a restatement at the March 1, 2003 meeting. Indeed, the court found that "there was no evidence presented at trial that anyone at AFC ever considered a restatement of AFC’s earnings prior to the March 1, 2003 meeting," and in any event no decision to restate was made until the March 10, 2003 audit committee meeting.

The court also found that the carrier had not carried its burden of showing that there had been misrepresentations at the January 24, 2003 underwriting meeting.

In addition, the court found that the company did not violate its duty to update the application material, holding first that there was no information that needed to be updated, and that even assuming for the sake of argument that a decision to restate financial would have required an update, the actual decision to restate did not take place until March 10, 2003, after the policy had incepted. (The court also specifically found elsewhere that timing of the company’s actions had nothing to do with the dates of the D & O renewal process.)

The court held that the company was entitled to recover the full $20 million policy limit plus prejudgment interest of over $4 million. However, the court rejected the company’s bid for statutory bad faith damages of $10 million, holding that even though the carrier’s attempt to rescind the policy had failed, the carrier had "reasonable and probable cause for its coverage decision."

In finding the carrier’s position to have been reasonable even if ultimately unsuccessful, Judge Pannell noted that "the timing of the restatement announcement suggested that AFC might have known more about a possible restatement than it disclosed" to the carrier before the policy incepted, and after the restatement announcement, the carrier "promptly initiated and conducted an investigation." The court further noted that the company’s "lack of cooperation in that investigation reasonable added to [the carrier’s] belief that AFC had been less than forthcoming in the negotiations for the policy."

One very odd aspect of the case relates to the correct amount of the policy limits at issue. You wouldn’t think there would be much question around an issue like that, and indeed the parties stipulated in pretrial filings that the aggregate limit of $20 million under the dual coverages was at issue. However, the carrier later sought to amend its pleadings to allege that only the $10 million D & O limit was available. There was in fact trial testimony that the company had only paid for the $10 million D & O limit and that the issuance of the policy with the dual limits had been due to a computer error.

Judge Parnell clearly was not happy with the post-trial motion in light of the pretrial stipulation that the full $20 million was at issue. Judge Parnell’s opinion reviews testimony showing that the carrier’s underwriters and claims attorneys were previously aware that the policy had been incorrectly issued, but that the carrier "had made a conscious decision" not to raise the issue in the pleadings, in order to be able to argue that the company had "increased its limits." (I am extrapolating here, but I guess the argument was something like this: the company knew the restatement was coming so it withheld the information about the restatement to be able to increase its limits, so that more insurance was available for the ensuing claim.) This testimony and the tactical maneuvering, as well as other aspects of the underwriters’ testimony, clearly left a negative impression on Judge Parnell. In any event, he rejected the carrier’s attempt to argue that only $10 million was at issue.

The carrier undoubtedly feels ill-used by the court’s opinion and is considering its appeal options. The reality is that until the court superimposed a layer of precision on the record through its factual findings, the record was murkier than might be supposed from the court’s opinion alone. Indeed, the court itself noted that the FAS 144 issue had arisen as a serious question before the March 1 date when the court said the issue of a possible restatement first arose. And as the court itself noted, the temporal proximity of the renewal date and the restatement not unreasonably raised questions about the company’s renewal disclosures. The carrier may also have had to make decisions about whether or not to rescind without the benefit of complete information, owing to the company’s refusal to provide information. For these reasons, it would be unfair to second-guess the carrier’s position based upon the ultimate outcome.

A Few Final Thoughts about D & O Policy Rescission: While I would not presume to second-guess the carrier’s position here, I do think it is fair to note that the D & O industry as a whole remains deeply conflicted about rescission. (I should emphasize that none of the following remarks are intended to reflect in any way upon the actions of the carrier in the AFC Enterprises case; these remarks related to rescission as a general issue, not to the any particular case.) For the insurance professionals involved on the transaction side of the business, rescission is a potent but theoretical concern that can somehow be fixed with policy language tinkering, while for claims professionals, rescission (or at least its threat) is just a tactical weapon, merely another tool in the toolkit to be used in claims resolution. The disconnect between the assumptions on the transaction side and the practical reality on the claims resolution side remains a problem for everyone in the D & O industry, and particularly for D & O insurance policyholders.

Short of making all policies nonrescindable under any circumstance (not likely to happen), rescission will remain a troublesome issue for the D & O industry. Both policyholders and carriers would be better off it were more widely recognized that policy rescission wreaks havoc on all concerned. There is not only the litigation expense, but there is also the reputation risk involved for the carrier – I guarantee you that, in light of Judge Pannell’s pointed remarks in his opinion, the carrier representatives who were involved in the AFC renewal and rescission now have a deeper appreciation for the reputational risk involved when a carrier attempts to rescind a policy. Indeed, my own experience has taught me the hard way that even when a carrier prevails in a rescission case, the carrier’s reputational damage may outweigh the benefit of the successful policy rescission. Rescinding a policy is like setting of an unusually powerful bomb – even if using the bomb seems necessary and appropriate, you can’t always predict the extent of the collateral damage.

My proposal to address the rescission issue is to suggest that the decision whether or not to rescind a policy should rest exclusively with the business unit head, rather that with a claims manager. The business unit head would be much more likely to consider the business context of the rescission decision. I would never argue that carriers must perform even if a policy has been procured through active fraud. However, I think the industry would be much better off if the rescission standard were raised sufficiently high that only active fraud would trigger a rescission and that in all gcases, consideration of business reputation would act as a check against exercising the rescission trigger. The superimposition of these kinds of controls might help eliminate the disconnect between the transaction and the claims sides of the business when it comes to the issue of rescission.

A September 27, 2007 Business Insurance article discussing the AFC Enterprises rescission case can be found here. A September 28, 2007 CFO.com article discussing the case can be found here.

Speaker's Corner: On October 10, 2007, I will be speaking at the C5 D & O Liability Insurance conference in Cologne, Germany on the topic "The Vulnerability of European Insurers and Reinsurers to U.S. Claims." The complete conference agenda can be found here.