Right of Rescission

Canadian courts haven’t yet dealt directly with the issue of the rescission of a D&O policy. If a rescission case is introduced in Canada, it is more likely that recent US court decisions on the issue will lead to confusion rather than clarification. Assuming the most current US court decision on the matter holds – and that insurers can unilaterally rescind D&O policies – what will that mean for future E&O policies?

A number of high-profile D&O claims in the United States have put the issue of rescission on the minds of many in the insurance industry – including the minds of those exposed to D&O liability. Cases such as WorldCom, Cutter & Buck and Tyco have helped define the right of insurers to rescind policies for misrepresentation. The recent, highly-publicized attempt to rescind Nortel’s D&O policy has awakened many Canadians to the fact that issues in the United States also affect us north of the border.

Rescission is not confined to the D&O policy. Insurers rely on representations and statements of the insured in determining coverage and premium for each risk. A material misrepresentation, innocent or not, can be used to justify rescission of the policy. The potential for rescission exists wherever a “reasonable insurer” would have refused to issue the policy, or would have offered premiums, terms and conditions different from those in fact offered.

An important question regarding rescission is when does an insurer’s obligation to defend a claim end? Until recently, it has been generally accepted in Canada that the contract remained in force until voided by judicial approval of the insurer’s position. Simply put, the insurer must continue to defend the claim during rescission proceedings and until such a time as a decision is made. This protects insureds from having their coverage rescinded by the insurer without judicial approval.

Unfortunately, from a Canadian perspective, there are no direct Canadian precedents for rescission of a D&O policy. Canadian courts may therefore look to British or American cases for guidance. A recent case in California seems to contradict the approach outlined above, and raises concerns that insurers may be able to unilaterally rescind policies without the requirement for judicial approval.

CONFUSION IN US LAW

On Oct. 11, 2005, in Atmel Corporation v. St. Paul Fire & Marine, a federal district court in San Francisco held that insurers may rescind their insureds’ policies without a prior judicial order and may thereafter extinguish any defense obligations they might have had for a pending claim. The decision emerges in contrast to authority rendered in other jurisdictions involving high profile companies such as Tyco International and Adelphia Communications Corporation.

In Atmel, one of Atmel’s customers, Seagate Corporation, sued Atmel after a dispute involving the sale of allegedly defective computer chips. In its decision, the court noted that Seagate notified Atmel of a problem in the fall of 2001. Atmel subsequently executed an application for E&O insurance, representing that it had not been aware of any circumstances that might reasonably give rise to a claim. As alleged by Atmel’s insurer, St. Paul, this representation was false in light of Atmel’s purported knowledge of the Seagate issues.

Seagate filed its commercial suit against Atmel in 2002. After wrangling over various coverage issues for more than two years, Atmel sued St. Paul, demanding that St. Paul honour its duty to defend the Seagate litigation. Shortly thereafter, in 2004, St. Paul unilaterally rescinded Atmel’s E&O policy and offered Atmel a refund for premiums paid on the policy, which Atmel rejected. St. Paul denied coverage for any additional defense obligations as a result of the rescission.

The court considered whether St. Paul could extinguish its duty to defend by means of a unilateral rescission of the policy based on alleged misrepresentations in the application for insurance. It also considered whether St. Paul must continue to defend Atmel, pending a judicial order of rescission?

In ruling in favor of St. Paul, the court stated: “Where grounds for rescission exist and the insurer properly exercises its right to rescind, the insured’s contract rights are extinguished ab initio (as if the policy had never existed). An insurer may avoid any liability for benefits provided under the policy, even on pending claims: ‘[A] rescission effectively renders the policy totally unenforceable from the outset, so that there never was any coverage, and therefore no benefits are payable.'”

By permitting the insurer to rescind the policy without first obtaining an order, the court implicitly gave St. Paul the power to decide for itself whether the legal standard for rescission had been met – for example, whether the grounds for rescission in fact existed and whether the company in fact properly exercised its right to rescind.

The court’s analysis in this regard appears to deviate from authority in other jurisdictions, which requires insurers first to obtain a rescission order. In the cases involving the financial scandals of Tyco and Adelphia, for example, two separate courts issued decisions on the rescission issue in March 2004. In both cases, the courts found an insurer that unilaterally rescinds a policy – in those cases, a D&O policy – must continue to fund defense costs incurred by insureds during the time that the insureds challenge the rescission.

As the court stated in the Adelphia matter: “Insurance carriers do not function as courts of law. If a carrier wants the unilateral right to refuse a payment called for in the policy, the policy should clearly state that right. This policy does not do so.”

WHERE DOES ATMEL FIT?

It is important to note that the court in Atmel did not make any findings on the soundness of St. Paul’s decision to rescind. Rather, in denying Atmel’s motion for summary judgment, it determined the facts relating to Atmel’s representations in the application were sufficiently disputed that the court could not decide the ultimate rescission question on the merits. The court did say, however, that until the propriety of an insurer’s rescission action is finally determined on the merits, the insurer may disclaim any interim coverage obligations. This is where Atmel conflicts with the decisions rendered in Federal Ins. Co. v. Tyco Int’l Ltd., (N.Y. Sup. Ct. Mar. 5, 2004) (Tyco) and in Associated Electric & Gas Insurance Services v. Rigas, which dealt with the Adelphia matter.

On the basis of Atmel – which was issued without even a reference to Tyco or Rigas – insureds might not feel confident that their defense costs will be paid by insurers who rescind policies based on unilateral findings. Although in similar cases coverage litigation against rescinding insurers is likely to follow, insureds run the risk that defense costs in the underlying action may remain unpaid while the rescission dispute plays out.

RAISING QUESTIONS FOR E&O

In the area of D&O insurance, the question of rescission and the protection of “innocent” insureds (insureds that were unaware of misrepresentations in the application for insurance) has resulted in significant negotiation of policy wording, specifically around the “severability” clauses within policies. Such clauses typically state that the knowledge of one insured shall not be imputed to other insureds for purposes of coverage. As insureds under the D&O policy, board members and those in senior management have demanded such protections – particularly in light of the negative impact that rescissions, based on the misdeed of a few, might have on the personal assets of important innocent individuals.

Little has been said, however, about the need for similar protection in other management and professional lines of coverage such as E&O. Atmel appears to require that these and other underwriting concerns be addressed. F or example, the following questions may be asked:

* Since E&O policies not only insure the company and its executives, but also all employees, can “severability” or similar clauses be designed to include and protect innocent insureds from rescission? Or, where such protection may already exist, should insureds and their brokers address the adequacy of the protection?

* Can applications themselves provide severability protection on awareness-based questions – for example, questions pertaining to known claims or circumstances – the way many long-form D&O policy applications do?

* Can an E&O policy’s “prior knowledge” exclusion be crafted to limit coverage for claims only upon a showing that individuals in certain identified senior positions had such knowledge?

* Similarly, can claim and potential claim notification clauses be written so as to be triggered only upon the knowledge of such matters by identified senior officials?

* Can policies be negotiated to provide that if an insurer believes it has a right to rescind, the parties will agree to adjudicate or possibly arbitrate the matter before defense obligations are extinguished? Can this be done without jeopardizing the insurers’ ability to invoke other policy limitations, such as exclusions that may apply in the absence of the rescission issue?

It is unclear how courts and insurers will respond next. What is clear, however, is the necessity for risk managers, brokers and insurers to work together to prevent the vulnerability of insurance programs to unilateral rescission, and explore ways to mitigate this exposure across all relevant coverage lines.