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Recruiting qualified individuals to serve as directors has always been a paramount concern for public companies, and the possibility of personal exposure of directors has always been a significant consideration in the decision to serve. Many of these fears have been allayed over the years by the increasing availability and limits of directors' and officers' liability insurance, as well as enhancements in such coverage seeking to offer protection from shareholder and other suits.

However, the ever-increasing number of securities settlements, regulatory investigations and criminal proceedings have grabbed the attention of corporate directors and officers. The possibility of bankruptcy and a loss of indemnification by the corporation, coupled with the possibility of rescission of the directors' and officers' coverage, have made corporate directors and officers even more concerned about their own personal financial exposure.

These individuals often find themselves in the position of losing coverage under the directors' and officers' policies when other insureds, without their knowledge, supply inaccurate information when applying for that coverage, including the submission of financial statements that turn out to be inaccurate and are subsequently restated.

While some insurers have sought rescission only as to the directors and officers involved in or having knowledge of the wrongdoing, others have sought rescission as to all directors and officers. Whether such wholesale rescission is warranted is greatly dependent on the language of the policy and the application submitted by the company. In electing to serve, it is essential that the individual have an understanding of rescission and be fully aware of the directors' and officers' insurance program of the company.

An insurer's underwriting decision in issuing a policy is based upon information provided by the insured during the application process. This information generally includes the most recent financial statements of the company. When the information provided is discovered to be incorrect or incomplete in a "material" way, the insurer may have the right to rescind the coverage. In this context, "material" means that the insurer would not have issued the same coverage on the same terms had it been aware of the accurate information. It is not necessary for the insurer to prove that it would not have issued coverage. Instead, if the insurer can prove that it would have issued the coverage with different terms or at a different price, the right of rescission may exist.

In many states, it is not necessary for there to have been an intent to deceive the insurer in providing the information, or that the insured was even aware of the inaccurate information. Even an innocent misrepresentation or omission can result in rescission. For example, where financial statements are submitted as part of the application, and the individuals signing the application believe the financial statements to be accurate at the time they are submitted, a right of rescission may still exist if it is later determined that the financial statements were inaccurate in some respect. In this situation, even the directors and officers that had no involvement in applying for the coverage or in preparing the financial statements could lose their directors' and officers' coverage.

THE QUESTION OF SEVERABILITY

For this reason, most directors' and officers' policies sold today contain some form of "severability" clause that limits the insurer's right to rescind the coverage as to certain directors and officers by treating each insured separately in terms of applying certain defenses to coverage. Different types of severability clauses provide different levels of protection to innocent directors and officers.

A full severability clause prohibits the knowledge of one insured from being imputed to other insureds. While this, in theory, provides the most protection to "innocent" directors and officers, it might not prevent an insurer from rescinding coverage. Certain states do not require knowledge of a misrepresentation in order to rescind a policy, and an innocent misrepresentation is enough to void coverage. Because knowledge is not necessary, it is irrelevant that the innocent directors and officers cannot be charged with the knowledge of others. While at least one court has rejected an attempt by an insurer to rescind coverage under such circumstances, this is no guarantee that other courts will follow and provide protection to innocent directors and officers under a full severability clause.

More limited severability provisions that are now commonly used serve to impute the knowledge of anyone that signs the insurance application to all other insureds, but provide severability in all other instances. Under such circumstances, innocent insureds could lose their coverage when the officer signing the application had knowledge of inaccurate information being provided to the insurer. Because most insurers require senior officers to sign the application, there is still a significant possibility that the innocent insureds could lose their coverage. Those senior officers in many instances would be the individuals that would have knowledge of fraudulent or other improper practices.

One federal court has recently upheld a decision granting rescission of a policy in its entirety under such circumstances. In Cutter & Buck Inc. v. Genesis Ins. Co., the policy provided that it would be void in its entirety "in the event that the application, including materials submitted therewith, contains misrepresentations made with actual intent to deceive." The policy also provided that "no knowledge possessed by any director or officer shall be imputed to any other director or officer except for material information known to the person or persons who signed the application."

The insured company admitted that its former chief financial officer made material misrepresentations in applying for the policy, but argued that such knowledge should not be imputed to the innocent insureds. The court held that the clear language of the policy permitted the insurer to rescind the policy as a whole under such circumstances.

TAKING "SIDES"

The risk of rescission has led some insurers to begin marketing nonrescindable side A excess directors' and officers' coverage. Side A provides coverage for loss incurred directly by the individual directors and officers that is nonindemnifiable, where the company is either not permitted or is financially unable to indemnify the directors and officers. Side B provides reimbursement to the company when it has or is permitted to indemnify its directors and officers. Side C, on the other hand, provides coverage to the corporate entity itself. One danger of having only a single policy that has side A, B and C coverage is that a single catastrophic loss under side B or C could exhaust the entire limits of the policy, leaving the individuals exposed for any future claims.

In order to provide protection to the individuals, and because most claims fall under side B as indemnifiable claims, insurers are increasingly offering side A-only policies that are nonrescindable. Such coverage offers dedicated limits that apply only to the individuals and is not shared with the corporate entity.

These policies also provide that, even when misrepresentations are made in the application, the policy cannot be rescinded as to any individual insured who did not have knowledge that facts were not truthfully and accurately disclosed to the insurer. While any insured that participated in or had knowledge of the misrepresentations may lose their coverage, the innocent insureds should be protected.

It is therefore essential that directors and officers understand the provisions in their D&O policies, especially where their service is to begin after such coverage is already in place, as the events that may ultimately lead to a loss of their coverage have already taken place. These considerations will certainly pertain to the qualified individuals that are asked to serve on the boards of public companies. Whether these recent developments have an effect on the ability of corporate America to recruit the most qualified individuals to serve remains to be seen, but they have certainly created potential obstacles that will have to be factored into the decision of whether to serve.

ANDREW L. MARGULIS is a partner in the New York office of Ropers, Majeski, Kohn & Bentley. He is an expert on directors' and officers' and professional liability litigation.

April 1, 2006

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