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Misrepresented Coverage: Will Your D&O Insurance Survive?

Date

February 21, 2007

AUTHOR(s)

Junior Sirivar


It is well established that a D&O insurer is entitled to rescind a policy of insurance that has been issued on the basis of a material misrepresentation of fact in the insurance application.

A misrepresentation of fact will be considered material if a prudent insurer would take it into account in determining whether to issue the policy or in setting the premium. Currently, D&O insurers often require that corporations append their most recent financial statements to the application for insurance in order to assess the corporation’s financial health. There is clear authority for the proposition that the general health of a company is itself important to the insurer’s decision to issue the policy. As a result, any misrepresentation of the company’s financial position either as reflected in the financial statements or otherwise, will likely be found to be material to the insurer’s decision.

Thus, the issuance of false financial statements exposes the company, its directors and officers, to civil liability from investors and creditors. This is precisely the type of risk that would be covered by a D&O policy. Therefore, attaching the financial statements to the insurance application implicitly represents that the statements do not include any inaccuracies that might result in this sort of liability. As a result, any inaccuracy in the financial statements may be found to directly material to the insurer’s decision to issue the policy.

In the event the corporation is required to restate those financial statements (as numerous recent cases exhibit), the insurer can be expected to rescind the policy on the basis of a material representation leaving all insureds under the policy without the benefit of insurance. This is notwithstanding the fact that many of them could not reasonably have known of any inaccuracies in the financial statements.

Misrepresentations in financial statements attached to an insurance application may be a sufficient basis for insurer’s rescission of the policy depending on their materiality. As a result, one insured’s misrepresentations can effectively deprive the other insureds of the benefit of the policy, even though they might not have been aware that the application included any materially false information. This is because the typical language of a D&O policy is drafted such that there is a strong argument that there is an intention to bind all of the directors to the accuracy of the representations set out in the application.

As a result, it is of paramount importance for the officers and directors to ensure that a clearly-worded severability clause limiting the insurer’s right of rescission to those directors and officers who are actually guilty of making the misrepresentation, is included in the policy. In the absence of such a clause, the insurer will likely be entitled to rescind the policy in its entirety.

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