Unilaterally Rescinded D&O Policy – Should an Excess Insurer Still Advance Defense Costs?

It is commonly accepted that providing false or misleading information as part of an insurance application can lead to the rescission of an insurance policy.

The elements required for rescission vary from state to state, and are often governed by statutes. Indeed, only in a minority of states is the law of rescission governed purely by common law principles.

Although the specific requirements for rescission differ from state to state, generally an insurer must prove the following: (1) the making of a representation; (2) the falsity of the representation; (3) the representation was material; and (4) the insurer relied upon the misrepresentation. Notably, while virtually all states require these first four elements, only some states require the element of intent or scienter – that the misrepresentations must have been willful, knowing, or made with intent to deceive the insurer.

The question presented in a recent case was whether an insurer could be required to advance defense costs for an excess D&O liability policy that was unilaterally rescinded by the insurer based upon a contention that allegedly false financial statements were submitted with the application of insurance. In re: WorldCom, Inc., Sec. Litig., __ F.Supp.2d __, 2005 WL 254684 (S.D.N.Y. Feb. 3, 2005).

Some of the facts regarding this case are relatively well known as they involve WorldCom’s well-publicized financial difficulties. In June of 2002, WorldCom announced a significant restatement of its financial statements and subsequently filed for bankruptcy protection in July of 2002. WorldCom and its officers and directors were insured under a primary D&O liability policy issued by National Union Fire Insurance Company of Pittsburgh, Pennsylvania.

Of note, the National Union policy included a term that “the insurer must advance defense costs payments pursuant to the terms herein prior to the final disposition of a claim.” In November of 2002, WorldCom and National Union reached a settlement. As part of the settlement agreement, the National Union D&O policy was rescinded and voided ab initio as to WorldCom only. Subsequently, National Union agreed to defend WorldCom directors and officers involved in WorldCom securities litigation and eventually exhausted its limits.

In September of 2002, one of WorldCom’s excess carriers, Continental, informed WorldCom that it considered its excess D&O liability policy to be void ab initio and viewed it as rescinded due to material misrepresentations and omissions by WorldCom and its officers and directors during the underwriting process. The instant decision evolved from a motion by a member of the WorldCom board of directors seeking a preliminary injunction requiring Continental to advance the costs the director had spent and was expected to continue to spend defending himself in securities litigation involving WorldCom.

In response, Continental maintained that the board member should be required to show that he could defeat the rescission defense before Continental should be required to advance defense costs.

The federal district court ruled that pursuant to New York law, the excess insurer was required to advance defense costs until the issue of rescission is adjudicated. The Court reasoned that the excess policy explicitly followed form to a primary policy requiring the insurer to advance defense costs prior to the final disposition of a claim brought against the insured. The Court summarized its holding by stating, “[u]ntil the issue of rescission is adjudicated, a contract of insurance remains in effect and the duty to pay defense costs is enforceable.”

Of note, the Court also rejected Continental’s arguments that the insured has the initial burden of demonstrating the likelihood of defeating Continental’s rescission defense. Instead, the court viewed the insured’s burden as having to show, under the terms of the policies, that he is entitled to defense costs as they are incurred. Such an obligation would exist until the rescission issues have been litigated and resolved.

The case represents how aggressively some insurers have embraced the use of rescission with respect to alleged misrepresentations made during the underwriting of D&O liability policies. The case also highlights that many courts will require an insurer prove its case with respect to misrepresentation before it can refuse to honor the terms of the policy.

Thus, insurers may find it difficult to “unilaterally” rescind their policies even in situations where it appears that the insured has provided false or misleading information during the application process.

Andrew S. Boris is a partner in the Chicago office of Tressler Soderstrom Maloney & Priess. His practice is focused on litigation and arbitration of insurance coverage and reinsurance matters throughout the country, including general coverage, directors and officers liability, professional liability, environmental, and asbestos cases. Questions and responses to this article are welcome at aboris@tsmp.com The Tip of the Month runs each month on claimsguides.com