In a recent decision by the United States District Court for the Northern District of California, the court held that an insurer does not have to provide D&O insurance coverage to a group of bondholders who took on the responsibilities of the bankrupt insured.  The ruling was based on the insured’s failure to disclose in the policy application a written demand letter alleging a breach of fiduciary duties.  See Admiral Ins. Co. v. Sonicblue, Inc., No. C07- 4195 JF, 2009 WL 2512197 (N.D. Cal. Aug. 14, 2009).  A copy of the decision can be found here.

The written demand letter alleging breach of fiduciary duties arose from a dispute between Sonicblue’s directors and officers and its bondholders.  According to the decision, Sonicblue privately placed convertible long-term debt in the amount of $103 million, and then later an additional $75 million.  Sonicblue’s bondholders wrote letters to the company asserting breach of fiduciary duty claims against the directors and officers.  Shortly after the receipt of the letters, Sonicblue filed for bankruptcy.  Following the bankruptcy filing, the bondholders filed a lawsuit for breach of fiduciary duty and constructive fraud against the company’s D&O’s.  The D&O defendants removed the action to bankruptcy court as an adversary proceeding in Sonicblue’s Chapter 11 bankruptcy case.

Once the case was removed, the D&O defendants filed a claim with the insurer for defense and indemnity under the D&O policies issued to Sonicblue.  In turn, the insurer filed a declaratory action against the D&O’s, arguing that it had no duty to defend or indemnify them for the following reasons: (1) the demand letter predated the inception of the Policy; (2) the insured did not disclose the demand letter during the policy application process; (3) the known-loss doctrine precluded coverage; and (4) notice of the claim was untimely.  Additionally, the insurer sought to rescind the Policy based on the requirement in the Policy’s application that the insured disclose all written demands for money or services against the D&O defendants, and all those against Sonicblue.  In support of its position, the insurer argued that it “reasonably relied on the misrepresentations and/or omissions” in the application process when it issued the policy and that such “non-disclosures” were material to the insurer, and the insurer would not have issued the Primary Policy, or would have done so on different terms and conditions, had it known about any of those letters.

The court agreed with the insurer and held that the insureds breached the obligation set forth in the policy application by failing to report the demand letters received prior to the company’s bankruptcy filing.  Further, the court held that an insurer is entitled to rescission if a policyholder concealed or misrepresented a material fact in the insurance application.  The court noted that while the application did not request information with respect to an event that may give rise to a claim, it did request information related to “any demands” involving allegations of federal or state securities law violations.  The court noted the term “demand” in the application appeared to contemplate a formal proceeding as well as any demands related to alleged violations of federal or state law or written communications demanding a course of action based on the rights of the author.  Thus, the court concluded the bondholder letters constituted a “demand” as contemplated by the Policy application as it was not a mere “expression of dissatisfaction” but rather alleged a right had been violated and notified defendants litigation might ensue absent rectifying action.