The background

AIG had provided Directors and Officers liability cover to a US company, Smartforce. It then reinsured part of its exposure to Faraday. The reinsurance agreement contained a notification clause expressed to be a condition precedent to Faraday’s liability, which stated (to the extent relevant):

‘The Reinsured shall upon knowledge of any loss or losses which may give rise to a claim, advise the Reinsurers thereof as soon as is reasonably practicable and in any event within 30 days …’

In November 2002, Smartforce announced its intention to restate its financial statements for the past three years, which was followed immediately by a fall of 34 per cent in its share price. Disgruntled shareholders instituted proceedings against Smartforce, asserting that the value of their shares had been artificially inflated by the mis-statement of accounts. Smartforce notified AIG of these claims in December 2002. AIG, however, did not provide any notification to Faraday until April 2004. This was within 30 days of the shareholder actions being settled in a mediation.

Faraday refused to pay out on the basis that AIG had not complied with the notification clause. It argued that as soon as Smartforce’s share price had dropped by a third following the restatement announcement, there was a loss that may give rise to a claim, and that AIG had knowledge of that loss when it received the notification from Smartforce. Faraday should therefore have been notified within 30 days of that point.

Decision at first instance

In the Commercial Court, Mr Justice Morison disagreed with Faraday. He held that the relevant ‘loss’ must be that of the third party claimants seeking to recover from the original insured (in this case, the claimant shareholders), and that it must be an actual, rather than an alleged or potential, loss. It could not be said that there had been an actual loss caused by the default of Smartforce until that had been determined by judgment against the company or a settlement involving an admission of liability. AIG had not had knowledge of this actual loss until after the mediation settlement in March 2004, and had therefore given notification in time.

Morison J considered the case to be very similar to the earlier Court of Appeal decision in Dornoch. In that case, shareholders had brought claims against the directors of Coca-Cola alleging that false accounting statements had artificially inflated the value of their shares. Coca-Cola denied that there had been any misstatement and argued that the variations in share price were due to ordinary market fluctuations. The Court of Appeal held that the insurer could not have had knowledge of the shareholders’ loss until after Coca-Cola’s liability had been ascertained by judgment or settlement.

Court of Appeal decision

The Court of Appeal unanimously reversed Morison J’s decision and found in favour of Faraday.

Crucially, it decided that Dornoch was distinguishable in one vital respect. In that case, it could not be said that there was an event or any action on the part of Coca-Cola that triggered the shareholders’ loss. Coca-Cola denied any misstatement, and it was possible that market fluctuations had caused the change in share price.

In Faraday, Smartforce itself had announced that the accounts were required to be restated. Lord Justice Longmore thought that any suggestion that the immediate dramatic fall in share price was coincidence or market fluctuation ‘would be to shut one’s eyes to the obvious’. The loss envisaged in the notification clause is not necessarily the loss that will in due course constitute a claim, but any loss that may give rise to a claim. From the shareholders’ perspective, the sharp fall in share price was clearly a ‘loss’, and in the circumstances clearly one that ‘might’ give rise to a claim. AIG had knowledge of this loss when notified by Smartforce. By not notifying its reinsurers within 30 days of that point, AIG had breached the condition precedent in the reinsurance policy.

Comment

The Court of Appeal’s decision arguably makes sense if viewed in the context of the principal purpose of notification clauses – to allow (re)insurers to exercise their rights to participate in the defence and/or settlement of the underlying claim if so desired. That purpose can only be served if insurers are notified soon after the date of loss of the third party claimant. From the perspective of an insured or reinsured, the decision serves as a reminder (if any were needed) that a cautious approach to notification is always advisable.

Reinsurers may be tempted to view Faraday as a tightening of reinsureds’ notification obligations. The truth may be more complex. Regarding claims brought by shareholders arising from alleged false accounting statements, the combined effect of the Faraday and Dornoch cases appears to be that (depending always on the precise policy wording, of course) the notification obligations of a reinsured to his reinsurer are by no means certain, and may depend to a large extent on factors surrounding the original claims. What if, for example, the fall in share value was not so dramatic, or other events occurred in close proximity to the discovery of the alleged misstatement that could be said to have caused the ‘loss’?

To avoid these uncertainties, reinsurers should consider carefully before inserting standard form claims cooperation clauses into their policies. A tailored approach at the wordings stage can save time and expense when it comes to claims. In particular, using a clause that is insufficiently precise as to the meaning of ‘loss’ or ‘knowledge’ and/or designed for a different class of insurance will increase the risk of disputes of the type in Faraday and Dornoch. In his judgment, Lord Justice Longmore was critical of reinsurers’ practice on this, and described the clause used in Faraday’s policy as ‘apt for property damage insurance but inapt for liability reinsurance’ – the point being that damage to a house or a ship will be obvious, and readily identifiable as ‘loss’.