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INSURANCE NOTES

Severability Clause Did Not Bar Directors And Officers Liability Insurer From Rescinding The Entire Policy For Incorrect Financial Statements

10.25.2007
In July 2007, the Tenth Circuit Court of Appeals in ClearOne Communications, Inc. v. National Union Fire Ins. Co. of Pittsburgh, PA, 494 F.3d 1238 (10th Cir. 2007), demonstrated the importance of the precise language of a severability clause in determining whether a liability policy may be rescinded in full for inaccurate financial statements submitted with an application for insurance.

ClearOne applied for a directors and officers liability policy from National Union. As part of its application, ClearOne directed National Union to its website for a copy of its most recent financial statements. After the National Union underwriter questioned the ClearOne CFO about its 10-K and whether the financial statements were certified as required by Sarbanes-Oxley, National Union issued a directors and officers policy. About three months later, ClearOne announced that its financial statements for the past two years were not reliable due to revenue recognition problems. The announcement resulted in multiple shareholder suits and an SEC investigation.

National Union rescinded the policy on the ground that material misrepresentations were made in the application for insurance. A ClearOne director and ClearOne sued National Union for breach of contract and bad faith. The trial court granted summary judgment to National Union.

Applying Utah law, the Tenth Circuit stated that rescission in that case required that there be a misrepresentation relied on by the insurer that was either material or made with the intent to deceive. The Tenth Circuit decided the incorrect financial statements were misstatements, that the misstatements were material, and that National Union relied on the misstatements. ClearOne argued that in order for the financial statements to be a basis for rescission, they must be attached to and made part of the policy that was delivered and not merely incorporated by reference. That argument was rejected. However, the Tenth Circuit stated that Utah law required that the individual who signed the application (in this case, the CEO) knew or should have known about the misstatement for it to be a misrepresentation for purposes of rescission. Thus, a finding of fact was required for rescission.

The Tenth Circuit further concluded that a severability clause in the application did not prevent National Union from rescinding the policy in its entirety instead of only as to certain persons. The clause in the application stated as to three specific warranty questions in the application, "the facts pertaining to any 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 . . ." Noting that the severability clause did not refer to the question that requested the financial statements, the Tenth Circuit concluded the severability clause did not apply to misrepresentations in financial statements.

A situation not specifically addressed in the ClearOne decision or in other court decisions is the impact of a statement in some insurance applications that all persons proposed for insurance have authorized the signer of the application to make the statements for them, where the application also has a severability clause. Would an officer or director's knowledge of the misstatement then trump or negate any "innocent" misstatement by the signer of the application? It would seem appropriate in those cases that the signer's knowledge should be binding on all proposed insureds regardless of a severability provision. In ClearOne, where there was no such statement in the application, the Tenth Circuit commented that a corporate policyholder should not be able to defeat rescission by having an ignorant director sign the application while those with knowledge of the misstatement sat idly by.

The ClearOne decision gives ample warning to both insurers and policyholders that the specific language of the severability clause may be critical in rescission cases.

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