California Insurance - Material Misstatements in Financial Statements Warrant Rescission of Directors and Officers Liability Policy, Even as to "Innocent" Insureds
TIG Insurance Company of Michigan v. Homestore, Inc., No. B176533 (Cal. Ct. App., March 13, 2006)
Absent clear severability language, an insurer’s statutory rescission right is not limited by a policy provision that permits rescission of the entire policy if the person who signed the application did so with knowledge that
it contained material misrepresentations, and secondarily permits rescission as to non-signing directors and officers who knew that the application contained misrepresentations. Instead,
California’s Second Appellate District (Los Angeles) held that because the person who signed the insurance application knew that financial statements submitted with the application were false, the insurer had the right to
rescind the policy as to all insureds – even "innocent" directors and officers.
TIG issued an excess directors and officers liability policy to Homestore, Inc., based on Homestore’s submission of its Form 10-Q for the quarter ended March 31, 2001. In December 2001, Homestore announced that it was restating
its financial statements. Securities and derivative lawsuits followed the announcement, alleging that Homestore materially overstated its revenues. A criminal indictment also was filed, naming Homestore’s chief financial officer,
Joseph Shaw – the person who signed Homestore’s insurance application. Shaw later pled guilty to one count of conspiracy to commit securities fraud, admitting that from March through December 2001, he conspired to materially
overstate Homestore’s quarterly financials.
TIG sued to rescind the excess policy in its entirety based on the material misrepresentations that were contained in the financial statement submitted to its underwriters. Homestore’s "innocent" directors and officers
– i.e., those who neither signed the application nor were aware of the misrepresentations – claimed that TIG could not rescind the policy as to them based on the following "Representation" provision incorporated
into the TIG policy from the primary policy:
[I]n the event that the Application, including materials submitted therewith, contains misrepresentations made with the actual intent to deceive, or contain misrepresentations which materially affect either the acceptance of the
risk or the hazard assumed by the Insurer under this Policy, no coverage shall be afforded under this Policy . . . 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.
According to the non-signing directors and officers, even though Shaw knew that the financial statements submitted with the application were materially false, the penultimate clause of this provision protected them by assuring that
their coverage would not be affected by others’ misrepresentations in the application process.
The Court of Appeal disagreed. It recognized that California’s Insurance Code permits an insurer to rescind a policy as to all insureds whenever there is a material misrepresentation, unless the contract provides otherwise.
(Cal. Ins. Code §§ 659, 660.) The court read the policy provision as containing essentially two rescission rights, neither of which was inconsistent with the statute. First, the policy gave TIG the right to rescind its
policy in its entirety if the application or information submitted with the application was materially false, and the person who signed the application – here, Shaw – knew of the misrepresentations. Second, the policy
separately gave TIG the right to rescind as to non-signing directors and officers who actually knew about the misrepresentations in the application. The court reasoned, however, that
this second, more limited rescission right did not otherwise affect TIG’s broader right to rescind in the case of an application signed by an officer who had knowledge of false statements.
The court rejected the non-signing insureds’ argument that the policy’s Representation provision was reasonably susceptible to an interpretation that rendered the policy voidable only as to signers and not innocent non-signers.
According to the court, the insureds’ proposed interpretation would render the distinction between signers and non-signers non-existent, and ignore the overall admonition that the policy would be void in its entirety if one
or more individuals who signed the application knew of the false statement.
The court observed that policies are available that contain unambiguous severability provisions in which misrepresentations made by one director or officer are not imputed to others. While Homestore could have purchased such a policy,
its decision not to do so, and TIG’s enforcement of its rescission rights under the California Insurance Code, did not undermine the insureds’ reasonable expectations, or public policy.
On the merits of the rescission issue, the insureds argued that TIG was required to prove that the misrepresentations had a material effect on its acceptance of the risk, otherwise there would be no need for the policy’s "Representation" provision to refer to anything more than a misrepresentation made in the application. While the court noted that the insureds’ argument had merit as a matter of contract interpretation, "Homestore’s grossly misrepresented financial condition was material to the acceptance of the risk as a matter of law" based on undisputed facts showing that TIG’s underwriter relied on Homestore’s Form 10-Q in making the decision to issue the policy.