By Jordan Stanzler

Jordan S. Stanzler represents policyholders in claims against insurance companies. He is a partner with Stanzler Funderburk & Castellon with offices in San Francisco and Los Angeles, California. He can be reached at (415) 677-1463; JStanzler@sfcfirm.com

One twist in the Enron fiasco is the insurance story. Recent newspaper reports indicate that the insurance companies which issued Director and Officers policies want to rescind those policies on grounds of fraud. In the world of insurance, rescission is the dreaded "R" word - the atomic bomb in the arsenal of insurance companies. Rescission of an insurance policy cancels it retroactively and completely, as though it never existed in the first place. The policyholder loses all rights to coverage.

The idea behind rescission is that no one should lie on an application for insurance and defraud an insurance company. With that general proposition, there is not much dispute. The general rule is that a material misrepresentation or material omission voids the policy of insurance. But what is a material omission? There's the rub. A surprisingly large number of rescission cases are filed by insurance companies, to assert their right to cancel insurance policies.

Very few of these cases involve situations where the policyholder set out to defraud the insurance company. Most deal with gray areas. Two types of policies where applications for insurance play important role -- D & O policies and life insurance policies -- end up in the courts with considerable frequency. Most D & O applications include a provision requiring the signer to warrant that the information provided in response to questions on the application is true. Fair enough, but there is no standard D & O application form and many of these forms contain a "catch-all question" that says something like "tell us about any facts and circumstances that might give rise to a claim in the future." Well, just about anything might give rise to a claim in the future. Just about anybody can file a lawsuit about anything.

Typically, no one pays any attention to these provisions until disaster strikes - - in the form of huge lawsuit against the Directors and Officers. There are some insurance companies that will feign to be "shocked, shocked" that such a lawsuit has been filed. They will pull out the application for insurance and protest that here was a claim that the policyholder never mentioned: if the policyholder had written down that this lawsuit was going to be filed, the insurance company would never have issued the policy in the first place. Time to rescind. It's one thing if the policyholder got wind of a lawsuit that had not yet been filed, and ran off to get insurance for it, without disclosing the facts. But in most instances, the policyholder does not expect to get sued and seeks insurance for the unexpected. That is exactly what insurance is for - to protect against risk. Insurance companies are in the business of evaluating risk and charging premiums for it. No one can force an insurance company to issue a policy.

Are there any lessons here? Be careful when applying for insurance. Ask a broker for assistance. What you put down on paper - or what you don't put down on paper - may come back to haunt you.

Insurance companies have claimed with increasing frequency that policyholders committed misrepresentations in applying for insurance. This defense to coverage usually comes as a complete surprise to the policyholder. The insurance company may argue that the policyholder submitted a false statement, a misleading statement, or omitted material information.

This issue has particular significance with respect to Directors and Officers liability insurance. Applications, or "proposals", for such insurance commonly call for the identification of all facts known to any of the directors and officers that "might give rise to a claim" under the policy; or, in the alternative, an affirmation that the directors and officers are unaware of any such facts. Typically, the claims disclosed are excluded from coverage.

Corporate counsel should be aware of these issues when obtaining Directors and Officers Liability Insurance.

Case law imposes a duty on the applicant to answer the questions propounded without evasion, misrepresentation or concealment. Klapholtz v. New York Life Ins. Co., 219 N.Y.S. 64, 218 App. Div. 695 (1926); New York Life Ins. Co. v. McCurdy, 106 F.2d 181 (10th Cir. 1939), cert. denied 309 U.S. 656 91940). See 12A Appleman, Insurance Law and Practice, Section §7292, §7292 (1981).

When the insurance Company fails to make a specific inquiry, the insured is not under any duty to disclose its knowledge of facts or circumstances that would give rise to a claim. Scarburgh Co., Inc. v. American Manufacturers Mutual Ins. Co., 107 Misc. 2d 772, 778-79, 435 N.Y.S. 2d 997, 21001 (1979), aff'd, 439 N.Y.S. 2d 298 (1981) (silence of an applicant cannot be fraudulent)

In National Union Fire Insurance Company v. Continental Ill. Corp., 643 F. Supp. 1434 (N.D. Ill. 1986), the court adopted a strict rule requiring that an insurance company show that it specifically and clearly requested the particular information from the insured. The insurance companies argued that there were material misrepresentations about the financial condition of the bank, as set forth in financial statements "attached" to the application.

The court found for the insured. While the financial statements were attached to the application they were not expressly "made part of" the application by the terms of the policy. Further the insurance company failed to ask for a specific representation about circumstances which could lead to a loss during the relevant time period. The court noted that the insurance companies "got just what they asked for no more, no less. This game was played with their prescribed bat and ball, and they cannot be heard to complain [that the bank] should have substituted better equipment" Id. at 1444.

In Harristown Development Corp. v. International Ins. Co., Civil Action No. 87-1380 (N.D. Pa. 1988) (LEXIS ), the court found that the duty on the insured was only to answer what it is asked by the application. The insurer claimed that the insured made misrepresentations on its application by its failure to disclose an acrimonious relationship the company had with a state redevelopment agency. The court rejected this argument finding that the application asked only for negligent "facts, errors, omissions or breaches of duty that could reasonably lead to litigation" - - not all facts or circumstances that could possibly lead to litigation.

See also Rallod Transp. Co. v. Continental Ins. Co., 727 F.2d 851 (9th Cir. 1984), where the Ninth Circuit reversed the district court's ruling granting rescission to the insurer. The district court had based its decision on its finding that the insured had a continuing duty to disclose material facts up to the point in time the written policy was issued. The Ninth Circuit found that the insured's duty to disclose material facts ended when the contract is formed and did not continue up to the time the policy was issued.

In general, the insurance company must prove that a misrepresentation

  1. involved a material fact;
  2. constituted a false statement or omission and;
  3. was relied on by insurance companies in good faith in issuing the policy.

See Wedtech Corp. v. Federal Insurance Corp., 740 F. Supp. 214, 218 (S.D.N.Y. 1990); Shapiro v. American Home Assurance Co., 584 F. Supp. 1245 (D. Mass. 1984); Bird v. Penn Central Co., 334 F. Supp. 255 (E.D. Pa. 1971); Old Republic Ins. Co. v. Rexene Corp., Civil Action No. 10,970 (Del, Ch. Ct. July 13, 1990) (LEXIS) (ambiguous questions as to insured's merger possibilities interpreted in favor of insured).

The policyholder's good faith behalf may preclude recission. Policyholder's good faith belief precludes rescission. See National Union Fire Ins. Co. v. SeaFirst Corp., 662 F. Supp. 36 (W.D. Wash. 1986) the court found that negligent misrepresentations in the application alone would not justify rescission by an insurer. See also Citizens Bank v. Western Employees Ins. Co., 865 F.2d 964 (8th Cir. 1989) (applicants belief about whether any known facts or circumstances might give rise to future claim contained a judgmental component; therefore the insured's good faith belief as to the truth of this statements was sufficient to avoid rescission).

In most instances, an insurance company is permitted to rely on the representations made by the applicant and is not obligated to investigate their truthfulness. Parker Precision Products Co. v. Metropolitan Life Ins. Co., 407 F.2d 1070 (3d Cir. 1969). See 12A Appleman, Insurance Law and Practice, §7276 (1981).

However, the insurance company does have an obligation to investigate "red flags" or "warning bells" and therefore cannot stock its head in the sand. General American Life Ins. Co. v. Lee Castonguay, 984 F.2d 1518 (9th Cir. 1993) (insurance company ignored "tell tale danger signals" that should have alerted need for further investigation.). Moreover, if the truth of the statements is readily available to both parties, the allegedly defrauded party is not justified in relying upon the representations of the other. 12A Appleman, Insurance Law and Practice, §7296 (1981).


D & O insurance is vital to corporations and their officers and directors. Great care must be taken in applying for this insurance, to avoid later claims that the policy should be rescinded.


All materials copyright 1999-2003 by Stanzler Funderburk & Castellon LLP. All rights reserved.

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