Sometimes you just can’t win.
Under the law of most states, the doctrine of rescission provides that when a policyholder gives a materially misleading answer on an application for insurance, the court may hold it void ab initio,
meaning the policy is unenforceable from the outset, as if there had never been any coverage. But in Western World Insurance Co. v. Professional Collection Consultants, a split panel of the U.S. Court of Appeals for the Ninth Circuit put a new twist on the doctrine. It rescinded a D&O policy when the policyholder gave an answer that the panel majority considered misleading—even though it was factually the truth.
In August 2013, FBI agents executed a search warrant at the offices of Professional Collection Consultants (PCC), and thereafter subpoenaed several PCC employees and collected thousands of documents. The following February, PCC applied to Western World Insurance Co. for D&O insurance, filling out an application form that required a “Yes/No” answer to the following question:
None of the individuals to be insured … have a basis to believe that any wrongful act, event, matter, fact, circumstance, situation, or transaction, might reasonably be expected to result in or be the basis of a future claim?
PCC checked “No.”
Apparently, the insurer thought “No” meant the insured individuals did not have a basis to believe a wrongful act might reasonably be expected to result in a future claim. For, after learning of the FBI investigation, Western World sued for rescission of the policy. And, the Ninth Circuit agreed with the insurer that PCC’s answer was a material misrepresentation, because PCC was aware of circumstances—the FBI investigation—which could lead to a claim covered under the policy.
But, as dissenting Judge Berzon pointed out, something was amiss in this ruling. For the answer that PPC checked—“No”—was accurate. As a matter of plain English, “No” meant it was not true that “none of the individuals to be insured … had a basis to believe a wrongful act … might reasonably be expected to result in or be the basis of a future claim.” By checking “No,” PCC in fact put the insurer on notice that such a claim might be expected based on facts known to the insureds.
This didn’t impress the panel majority. The majority observed that instructions in the application form warned that a “yes” answer to any question would require the applicant to provide further information, and could change the terms and conditions of coverage. The majority’s implication was that PCC should have known that a “yes” answer was appropriate because the increased risk it was aware of should have come out in an accompanying explanation. PCC, having answered “no,” volunteered no elaboration. But as the dissenting judge noted, other questions in the application made it clear “that the admonition at the outset indicating that ‘Yes’ answers may require different policy terms … did not signify that ‘Yes’ answers are problematic in every instance.” For example, there were questions asking whether employees were given human resources information and training, and whether an attorney had updated the PCC’s employee handbook and its human resources policies and procedures. A “Yes” answer to those questions would suggest a reduction in relevant risk, not an increase in risk requiring explanation in the application. (It should be noted that there is authority for the proposition that an applicant for D&O coverage owes its insurer no duty to volunteer information in an application when the insurer hasn’t asked, and a policy may be voided only when it’s shown that the insured withheld material information in bad faith.)
This particular application form was singularly ill-written. A simple thought experiment shows why: If the court was correct in holding PCC’s “No” answer to be misleading, then the opposite answer—“Yes”—would have to be correct. That would mean no insured had a basis to believe a wrongful act could give rise to a claim. “Nothing to look at here.” But that answer, of course, would (also?) have been misleading.
Based on the majority’s ruling, the only conclusion is that giving either answer exposed PCC to rescission. It was a classic case of “damned if you do, damned if you don’t.” And, under that sort of reasoning, the D&O coverage for which PCC paid its premium was illusory from the start. The ambiguity was born in the application form, not in PCC’s answer. In such a case, the insurer should bear responsibility for the ambiguous application form it chose to use, not the policyholder.
Of course, before it paid its premium, PCC could have asked more questions about what was intended in the application form. It can be a mistake to assume an insurer knows what it’s doing, and when it comes to the risk of rescission, it’s a mistake to try to “game” a stupid question with a literal answer. So, while at least arguably the Ninth Circuit got it wrong, don’t count on the next court to get it right. When the stakes are this high, check with your broker. And before binding coverage, it’s always a good idea to check with qualified coverage counsel to make sure the policy, and even the application, say what you think they do.