AIG provided directors and officers cover (“the D&O Policy”) to Smartforce which was listed on the NASDAQ exchange. AIG reinsured a proportion of the US$15 million risk with, amongst others, Faraday. The reinsurance contract included a claims cooperation clause which stated:
“Notwithstanding anything contained herein to the contrary, it is a condition precedent to any liability under this Policy that:
(a) The Reinsured shall upon knowledge of any loss or losses which may give rise to a claim, advise Reinsurers thereof as soon as is reasonably practicable and in any event within 30 days….…”.
On 6 September 2002 Smartforce merged with Skillsoft. On 19 November 2002 the management of the newly merged enterprise announced that it intended to restate the financial statements of Smartforce for the previous three years. This led to a fall in the listed value of Smartforce’s shares. In March 2003 shareholders commenced class actions against Smartforce and various of its directors alleging that they had bought shares at artificially inflated prices and that they had lost money as a result.
On 22 September 2003 Smartforce filed its restated accounts. These showed a reduction in net income of approximately US$127 million and reduced shareholder equity of approximately US$81 million.
On 12 February 2004 AIG posted a reserve of US$7.5 million. The reserve represented a hit of US$2.5 million against the first layer of the reinsurance, of which Faraday reinsured 50%.
The claims were settled at mediation in March 2004 for US$30.5 million. A memorandum of understanding between the parties was signed on 23 March 2004. At this stage no agreement had been reached between Smartforce and AIG regarding the recovery under the insurance.
Faraday were notified of the loss on 19 April 2004.
In June 2005 AIG paid Smartforce’s claim under the D&O Policy for the full limit of US$15 million and sought to recover under its reinsurance. Faraday refused to pay the claim. It argued that it was not notified in accordance with the claims cooperation clause. More specifically Faraday argued that:
The clause obliged AIG to notify it of circumstances which might give rise to a claim against Smartforce, as well as actual losses, and that was not done as soon as reasonably practicable, or within 30 days of AIG’s knowledge of the same.
- Even if the clause only covered actual losses, AIG were aware of the losses when it was announced that Smartforce were to restate its financial statements on 19 November 2002. Notification was not therefore given within 30 days.
- Even if the losses were notified within 30 days, Faraday were not notified as soon as was reasonably practicable.
- AIG knew that the claimant shareholders had incurred legal fees and that Smartforce had incurred defence costs. These were losses for the purposes of the policy.
The claims cooperation clause was very similar to that which was considered in Royal & Sun Alliance v Dornoch 2005. Mr Justice Morison considered the decision of the Court of Appeal in Dornoch and reached the same conclusion:
- Loss for the purpose of the claims cooperation clause was that of the shareholders who were the claimants in the class actions.
- Actual loss was required. The words “loss or losses” are essentially different from “alleged” or “claimed” or “potential” losses. If that was what was intended then the parties could have used such language.
- The claimants do not suffer an actual loss until it is proved that they bought shares at an inflated value due to the default of the company directors.
Accordingly, the task for the court was to decide when AIG had knowledge of an actual loss, ie, whether this was over 30 days before 19 April 2004, when Faraday were notified of the loss.
Mr Justice Morison decided that AIG did not know about an actual loss until, at the earliest, 23 March 2004, when the memorandum of understanding was agreed between the claimants and Smartforce. It was at that stage that a “might be loss” turned into an actual loss for the purposes of the reinsurance. Had there been no settlement there would have been no actual loss, as at the time of the mediation there had been no disclosure or exchange of expert reports and there was no sound basis for concluding that there was any liability or any proved loss. AIG’s posting of reserves did not establish knowledge of a loss. Reserving was just a process by which insurance companies anticipate the possibility of a loss in a policy. In the circumstances, AIG had notified Faraday within 30 days of it becoming aware of an actual loss. Mr Justice Morison commented that he suspected that the issue of costs had only been raised to support the argument that “loss” meant “potential loss”. The loss referred to in the claims cooperation clause was the third party claimants’ loss attributable to the acts or defaults of the directors for which there was cover under the D&O Policy. It did not include the costs incurred by the claimants in proving their claim. In any event, on the facts, the settlement of the claims between Smartforce and AIG did not include a payment for such costs. Likewise, AIG were never asked to make any contribution to Smartforce’s defence costs, so no indemnity would be available in respect of these.
Faraday had also argued that the claims cooperation clause consisted of two conditions precedent, each of which must be fulfilled. First, to advise as soon as reasonably practicable and, secondly, to advise within 30 days. Mr Justice Morison dismissed this argument as “hopeless”. If that had been the intention behind the clause that should have been spelt out. In any event notice was given within 30 days and as soon as reasonably practicable.
In his judgment Mr Justice Morison took the opportunity to add to the growing criticism of the decision in Lumbermans Mutual Casualty Co v Bovis Lend Lease 2004, although his comments were obiter dicta. In the Lumbermans case it was decided that an insured could not rely on a settlement agreement covering both insured and uninsured losses as establishing insurers’ liability, if the settlement did not make an
attribution between insured and uninsured losses. Arguably the same principle would apply to a reinsured seeking to make a recovery under a reinsurance contract.
Mr Justice Morison doubted the “controversial” decision in Lumbermans and agreed with the comments made by Mr Justice Aikens in Enterprise Oil v Strand 2006. Namely that the “flaw” in the Lumbermans case was that the judge had rejected that extrinsic evidence could be used to explain the losses in a global settlement. Mr Justice Morison doubted that the decision in Lumbermans was correct but, in any event, he did not think that it could apply to a reinsurance case where there was a follow the settlements clause. However, until the decision in Lumbermans is overruled, reinsureds would be advised to ensure that any global settlement apportions liability between different heads of loss and insured and uninsured eventualities.