The United States District Court for the Northern District of Georgia, applying Georgia law, has held that an insurer was not entitled to rescind a D&O policy, finding that the policyholder made no material misrepresentations in its renewal application even though the policyholder made an announcement shortly after renewing the policy that it would restate its earnings. Executive Risk Indem., Inc. v. AFC Enter., Inc., 2007 WL 2791117 (N.D. Ga. Sept. 26, 2007).

The policyholder corporation changed auditors shortly before it renewed the policy. The new auditors had recommended changes to the company's accounting methods that might require a restatement of prior financial statements. The discussion regarding the accounting practices became contentious and eventually led to a restatement of the company's earnings. The company announced the pending restatement just days after the D&O policy incepted.

After the restatement announcement, several lawsuits were filed against the company for which the company sought coverage. The insurer promptly initiated a rescission investigation and ultimately rescinded the policy and brought this declaratory judgment action.

According to the court, the renewal application did not contain questions regarding possible financial restatements, and the insurer admitted that the company's answers to the questions in the renewal application were not false or incorrect. However, the insurer argued that the company's CEO had knowledge at the time he signed the application that the company's financial statements, which were deemed to constitute part of the application, were incorrect.

The court rejected this argument, reasoning that the insurer had not required the company to warrant any facts. Rather, the CEO only stated that the statements in the application were true to the best of his knowledge and belief. The court found that the insurer had not proven that the CEO knew the financial statements were incorrect at the time he signed the application.

The insurer also argued that the company's CFO had made material misrepresentations at an earlier meeting with account underwriters. At the meeting, the underwriters had asked: "Discuss your relationship with your new auditor. Have there been any significant changes in your accounting practices?" The evidence suggested that the CFO had answered that the company's relationship with the new auditor was "fine" or "professional" and that the auditor was currently assessing and documenting the company's internal controls. The court found that these answers were not incorrect because, at the time of the meeting, there was, at most, a discussion among the company's officers and auditors about new accounting guidelines and their application. The company had not yet changed any of its accounting practices or decided to restate the prior financial statements.

The court also rejected the insurer's argument that the company did not comply with its obligation to update its application because it failed to disclose the decision to restate its financial statements. The court opined that any duty to update was limited by the language of the policy, which required only that the applicant report "any material change in the answers to the questions [in the application] prior to the policy inception date." The court reasoned that the application did not ask about financial restatements, and the insurer admitted at trial that none of the answers in the application was false, even after the restatement. The court further determined that even if the decision to restate could be considered a material change to the answers, that decision was not made until after the policy incepted.

The court also concluded that the insurer failed to show that any purported misrepresentations in the application were material because the insurer never asked whether the Insured planned to restate its earnings. "If [the insurer] truly considered the prospect of a possible restatement of earnings to be material, it could have easily included a question in the Application inquiring about the subject, but chose not to do so." The court also stated that the underwriters acknowledged that they knew that the company intended to restate its earnings and knew that securities claims had been filed against the company when they approved issuance of the policy, which occurred after the date the policy took effect. The court asserted that the insurer's issuance of the policy with this knowledge was an acknowledgment that the purported misrepresentations were not material.

The court denied the company's claim for bad faith damages, holding that the insurer had reasonable cause for its coverage decision. The court acknowledged that the timing of the restatement announcement suggested that the company might have known more about a possible restatement than it had disclosed. The court also pointed out that the insurer had promptly initiated an investigation of the circumstances surrounding the issuance of the policy and that the company's lack of cooperation reasonably added to the insurer's belief that the company had not been forthcoming.