D&O Coverage Risks for “Innocent” Directors and Officers

A well underwritten D&O insurance policy should provide for full severability; i.e., permit coverage for innocent directors and officers in a situation where the carrier has valid grounds to rescind coverage for another individual insured. Typically, severability becomes an issue when the insurer attempts to rescind the policy and deny coverage as to all insureds based upon material misstatements or omissions in the application process. For example, in the recent In Re: HealthSouth Corp. Securities Litigation, several insurers attempted to rescind D&O coverage based on application misstatements after former HealthSouth officers entered guilty pleas and admitted that they engaged in a scheme to misrepresent the company’s finances. The court in that case relied heavily upon the language of the severability clause in HealthSouth’s D&O policy:

“With respect to the declaration of statements contained in such written application(s) for coverage, no statement in the application or knowledge possessed by any Insured Person shall be imputed to any other Insured Person for the purpose of determining if coverage is available.”

The Court in HealthSouth ruled that this full severability provision “preclude(s) rescission as to all insureds regardless of their involvement in the alleged fraud.”

However, in other recent cases some Courts have found that a D&O policy included only partial severability, resulting in misrepresentations or omissions by the officers signing the policy application being imputed to the innocent insureds and their coverage denied. Thus, in one case where the severability clause stated in pertinent part “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,” and the court found that the CFO knowingly submitted materials with the renewal application that included material misrepresentations, the insurer was entitled to rescind coverage for otherwise innocent officers and directors.

In another recent decision of the Ninth Circuit U.S. Court of Appeals, the Court upheld the carrier’s right to rescind coverage as to all insureds because of material misrepresentations made by the former CFO who signed the D&O application. In that case the severability clause had provided:

“In the event that the Application, including materials submitted herewith, contains misrepresentations…no coverage shall be afforded…for any Director or Officer who did not sign the Application but who knew on the inception date of this Policy the facts that were so misrepresented, and this Policy in its entirety shall be void and of no effect whatsoever if such misrepresentations were known to be untrue on the inception date of the Policy by one or more of the individuals who signed the Application.”

These cases illustrate that the mere inclusion of a severability clause in the D&O policy will not be determinative in the event the insurer attempts to deny coverage for innocent insureds where the application process was flawed by misrepresentations or omissions of material facts. It will be necessary in any such case to demonstrate that under the precise language and formulation of the severability clause in question, it was the clear and unambiguous agreement of the parties that there should be insurance coverage for the innocent officers and directors. Further, it may be necessary to convince a court that other relevant policy provisions, including language in the Application or any “warranty” or “representation” letter requested by the carrier, do not contradict the severability provision. In the event of such contradictory provisions, the court may conclude that the conflicting provisions create an ambiguity as to the proper construction of the policy, thereby requiring disregard of the policy language and inquiry into the intent of the contracting parties. Thus, what began as a difficult case may have become an impossible one.

The clear message here is that up-front attention to the language of the severability clause and any contradictory policy provisions can save much uncertainty and expense at a later time when the insurer is considering its coverage options.