D&O Liability - Tenth Circuit Reverses Summary Judgment for Insurer on Rescission Claim
On July 25, 2007, the United States Court of Appeals for the Tenth Circuit, applying Utah law, reversed and remanded summary judgment in favor of National Union Fire Insurance Company of Pittsburgh, Pa. (“National Union”).
In ClearOne Communications, Inc. v. Nat'l Union Fire Insurance Co. of Pittsburgh, Pa., No. 05-4294 (10th Cir. July 25, 2007), the Court held that the district court improperly granted summary judgment to National Union
on the issue of whether National Union properly rescinded a directors and officers (“D&O”) liability policy pursuant to Utah Code Ann. § 31A-21-105 (1994).
In September 2002, ClearOne applied for a D&O liability policy with National Union. In connection therewith, ClearOne completed an insurance application that required it to submit copies of various documents, including a 2002
Form 10-K. ClearOne directed National Union to its website to obtain the required documents. In questions 8, 9 and 10, the application asked about past and pending claims against the proposed insureds, as well as potential liabilities
that may give rise to a claim. The application included a severability provision, which provided: “It is further agreed that in regard to the applicability of questions 8, 9, and 10 above, the facts pertaining to
an[d] knowledge possessed by any Insured (other than the knowledge and/or information possessed by the person(s) executing the application) shall not be imputed to any other Insured Person; only facts pertaining
to and knowledge possessed by any past, present or future chairman of the board, president, chief executive officer [CEO], chief operating officer [COO], chief financial officer [CFO] and General Counsel . . . of the Organization
shall be imputed to the Organization.” (emphases added)
In early 2003, ClearOne admitted that its financial statements for the previous two years were not reliable and subsequently admitted that shareholders’ equity and net income had been substantially overstated. Several shareholders
lawsuits and an SEC investigation followed. ClearOne tendered the claims to National Union, and National Union rescinded the insurance contract ab initio based on the 2002 financial misstatements, on which it allegedly had
relied in issuing the policy. ClearOne and its director and largest shareholder filed this suit, alleging breach of contract and bad faith.
Utah Code Ann. § 31A-21-105 (1994) provides: “No misrepresentation or breach of an affirmative warranty affects the insurer’s obligations under the policy unless: (a) the insurer relies on it and it is either material
or is made with intent to deceive; or (b) the fact misrepresented or falsely warranted contributes to the loss.” Utah Code Ann. § 31A-21-105(2) (1994). The Court cited Derbidge v. Mutual Protective Ins. Co.,
963 P.2d 788 (Utah Ct. App. 1998) for its conclusion that a misrepresentation under Utah law is “something more than an innocent misstatement” and must involve a scienter element. Accordingly, the Court determined that
four elements are necessary for rescission: (1) a misstatement, (2) lack of innocence, (3) materiality, and (4) reliance. The Court concluded that National Union sufficiently demonstrated all elements except for “lack of innocence”
and remanded on that issue, stating that “[a] misrepresentation occurs if the applicant knows or should have known about a misstatement in the application and still presents it to the insurer.” The Court reasoned that
“Utah insurance law does not compel the per se imputation of any misstatement made in an insurance application to the corporation without first determining whether the application signor (or another corporate director)
had knowledge of the misstatement.” The Court found that National Union failed to establish that the signor knew or should have known about the financial misstatements attached to the application, and, as a result, remanded
the following questions to the district court: (1) whether submission of false financial statements in the corporation’s application met the scienter requirement under state law, and (2) whether the corporation’s bad
faith and punitive damages claims against the insurer survived summary judgment.
The Court also addressed the parties’ arguments regarding the policy’s severability provision. ClearOne argued that the policy’s severability clause prevented National Union from rescinding its policy ab initio. National
Union argued that the severability clause was irrelevant to the rescission analysis. The Court stated that the application of a severability provision was a “fact intensive, case-by-case inquiry dependent on the precise language
of the severability clause and the facts of the misrepresentation.” The Court reasoned that, by its language, the severability provision only applied to three questions in the application, and the misstatement at issue was
the inclusion of a false Form 10-K submitted pursuant to a different question. As a result, the Court held that the severability provision did not preclude National Union’s ability to rescind the policy in its entirety, noting
that the severability provision “would be ineffective against National Union’s rescission of the insurance policy in its entirety should the financials be deemed to be a non-innocent misrepresentation.” The Court
rejected ClearOne’s attempt to rely on the holding in In re HealthSouth Corp. Ins. Litig., 308 F. Supp. 2d 1253 (N.D. Ala. 2004), distinguishing that case on the basis that, in that case, the severability provision
was much broader, applying to the entire application.