DMC Category Rating: Confirmed

Background
AIG provided directors and officers ("D&O") insurance to an Irish company called Smartforce, which provided e-learning courses for the IT industry. On 6 September 2002, Smartforce merged with a USA corporation, SkillSoft. On 19 November 2002, the new management announced it intended to restate the financial statements of Smartforce for the previous three years (1999, 2000 and 2001) and for the first two quarters of 2002. The listed value of Smartforce's shares fell dramatically.

In March 2003, class actions were consolidated against Smartforce and various directors by shareholders alleging that they had bought shares at an artificially inflated value and had lost money as a result. The corrective financial statements were filed in September 2003 showing a significant reduction in the company's net income and shareholders' equity.

AIG took legal advice on whether it could rescind the policy if the financial statements were shown to be fraudulent, but it was still not yet clear whether this was the case, or whether the restatements merely reflected a more conservative accounting policy. In February 2004, it reserved for US$7.5 million and, shortly before the mediation in March 2004, noted that there was a possibility that the claim might exceed the limit of cover. At the mediation, the third party claims were settled for US$30.5 million without agreement as to insurance recovery.

AIG, however, did not formally notify its reinsurers until 19 April 2004. In June 2005, AIG paid out the full limit of indemnity under the insurance and sought to recover under its reinsurance. One of the reinsurers, Faraday, argued that it was not liable because AIG had breached the Claims Co-operation Clause ("CCC") in the reinsurance.

The underlying D&O policy was expressly subject to Irish law and included various retentions. In respect of securities claims in the USA, the retention was US$5 million and there was a requirement for co-insurance of 25%. AIG was, therefore, liable for 75% of a loss in excess of US$5 million. The overall limit to the cover was US$15 million excess the retention.

Following the merger, the policy was converted into a run-off policy covering risks arising out of claims made during an extended policy period of 6 years in respect of wrongful acts before the date of the merger.

AIG obtained reinsurance for its exposure in two excess layers: US$5 million excess of US$5 million excess the retention, and US$5 million excess of US$10 million excess the retention. At each level, Faraday provided 50% of the reinsurance cover.

The CCC in the reinsurance provided that it was a condition precedent to any liability under the policy that:

Faraday argued that the clause obliged AIG to notify it of circumstances that might give rise to a claim against Smartforce, as well as actual losses, and that this was not done as soon as reasonably practicable, or within 30 days. Even if the clause only referred to actual losses, AIG had been aware of actual losses when the shares fell in value and, even if the losses were notified within 30 days, this was not as soon as reasonably practicable.

AIG knew of the drop in share price in November 2002, after the announcement about the restatement, and the loss was quantified when the corrective financial statements were filed in September 2003. The posting of a reserve in February 2004 that affected the first layer of reinsurance was good evidence of AIG knowing of a substantial loss.

Lastly, Faraday argued that AIG knew that the claimants had incurred legal fees which would be recoverable against the insured, so an actual loss had been incurred. Alternatively, the insured's own costs in defending the claims were an actual loss of which AIG was aware. Neither loss was notified within the time limit.

Judgment
The CCC in question was one in common use. The wording was very similar to that examined by the Court of Appeal in Royal & Sun Alliance Plc v Dornoch [2005] 1 Lloyd's Rep IR 544, although the clause in that case was slightly tighter, in that the reinsured had to notify upon knowledge of any loss or losses which may give rise to a claim "under this policy...within 72 hours", and reinsurers had the right "to appoint adjusters, assessors and/or surveyors and to control all negotiations, adjustments and settlements in connection with such loss or losses".

Class actions were brought by third party claimants alleging that the directors had dressed up the company's financial statements in such a way as to enhance the level of the company's stock. Having bought shares at inflated prices, the claimants incurred large losses when prices fell.

The Court of Appeal held in RSA v Dornoch that "loss" in the notification clause meant actual loss, not alleged loss and agreed with the first instance judge that the loss referred to was that of the third party claimants. The reinsured did not have actual knowledge of that loss until it was a proved fact – that is, it was established that the price of the shares had been artificially high because the directors had overstated the company's worth.

As for the argument that there had been an actual loss as soon as liability for costs had been incurred, costs considerations could not influence the primary question of the meaning of "loss". That would be to let the tail wag the dog.

In short, the parties to the reinsurance in Dornoch had chosen a CCC ill-suited to liability reinsurance, which involved a complete mismatch between the underlying policy (written on a claims made basis) and the notification of loss required in the reinsurance.

Actual Knowledge of Actual Loss
The judge in the present case reached the same conclusion as the Court of Appeal in RSA v Dornoch. There was never a loss known to AIG until, at the earliest, 23 March 2004, when settlement was reached at the mediation. Formal notification was given on 19 April 2004, less than thirty days later. At that point, a potential loss turned into an actual, quantifiable loss for the purposes of the reinsurance.

Had there been no settlement, AIG would have had no knowledge of any actual loss, as the third parties' claims were far from being proven. As it was, the settlement was more of a horse trade than a carefully calculated deal. The judge commented that he might have had more sympathy if Faraday had argued that it was not bound by the follow-the-settlements clause because Smartforce had had no liability to the third party claimants.

The judge also disagreed with Faraday's breakdown of the clause into two separate conditions precedent, both of which had to be fulfilled, so that even notification within 30 days might not satisfy the requirement "as soon as reasonably practicable". If that had been the intention behind this draconian clause, it should have been spelt out clearly. A reinsured would reasonably think that there was one condition precedent, namely the 30 days. The other condition was not a condition precedent because the extent of the obligation was too uncertain. In this case, notification was given within the 30 days and as soon as was reasonably practicable.

A Comment on Lumbermen's
Lastly, the judge commented briefly on the controversial decision in Lumbermen's Mutual Casualty Co v Bovis Lend Lease [2005] 1 Lloyd's Law Rep 494, which had been raised in argument although it was not strictly relevant to the case.

In Lumbermen's, it was held that an insured could not rely on a settlement agreement as establishing a liability for the purposes of its liability insurance if the settlement did not specifically allocate sums between insured and uninsured heads of claim. Nor could the insured rely on extrinsic evidence to prove its insured loss.

The decision was strongly criticised by Mr Justice Aikens in Enterprise Oil Ltd v Strand Insurance Company Ltd [2006] 1 Lloyd's Rep 500, who could find no principle that stated an insured could not rely on extrinsic evidence to prove its liability to a third party for a particular sum under a settlement or that that sum represented a loss covered by the policy.

The judge in this case agreed. He did not think that Lumbermen's could apply to a reinsurance situation where there was a follow-the-settlements clause. It did not apply to this case because the settlement did not involve insured and uninsured losses. But in any event, the Lumbermen's point was a bad one "because the decision which established it is, in my respectful view, unsound and should not be followed. In every case it is simply a matter of evidence to establish what the insured losses were; and the court should receive such evidence as the parties wish to advance on the question, without any preconceived notions of admissibility".

Comment
As in the recent case of RSA v Dornoch, the root cause of the problem was the mismatch between the underlying liability cover and a notification provision in the reinsurance that would have been more suitable for a property damage policy.

The comments on Lumbermen’s demonstrates a growing body of judicial dissatisfaction with that decision, but of course they are not binding. Until such time as a future case brings the question before the Court of Appeal, the recoverability of global settlements remains unresolved.

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