When is Rescission Based Upon Material Misrepresentations The Proper Course of Action?

Carriers rely on application representations regarding the existence of potential claims.  Sometimes, the carrier learns after the fact that an applicant may not have reported all known potential claims.  What can/should the carrier do?  A recent example is found in Continental Casualty v. Gargoyles, a case involving allegations of securities fraud.  Continental extended a defense under a reservation of rights, which it later sought to withdraw when the president of Gargoyles confessed to criminal wrong-doing as part of a plea agreement.  In this case, the facts confessed in the plea agreement contradicted the reported claims in the insured’s policy application.  Once the plea agreement was confirmed, Continental moved to rescind the policy and recoup its defense costs.  The court held that the policy was void from inception based on the insured’s misrepresentations in the application.

Stop DominosAlthough such an outcome seems obvious, a carrier must always look at state statutes governing policy rescission, as some statutes may limit the ability to rescind a policy, even when the misrepresentations are clearly material.  Continental also argued that it should be able to recover its defense costs expended before the policy was declared void.  Many E&O/D&O policies contain an explicit cost recoupment provision, although the Continental policy at issue did not.  The Court seemed to concede that a recoupment right would exist, yet the Court withheld a ruling on recoupment because Gargoyles argued that a Continental employee had waived such a right by stating that Continental “would pay defense costs to the end.”  Recoupment under facts such as these makes good legal (and equitable) sense due to the insurer’s agreement to defend under what amounts to false pretenses.  Whether and when to rescind, as well as what additional relief to pursue, should be weighed carefully as these questions present significant legal and strategic issues fraught with potential bad faith ramifications.

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