Background of Clearone

Written by fuying

January 28, 2008 13:30

ClearOne is a publicly-held, audio conferencing products company in Salt Lake City, Utah. National Union of Pittsburgh, Pennsylvania provides comprehensive commercial insurance policies for businesses. Edward Bagley is ClearOne's single largest shareholder and is on the board of directors.

In September 2002, ClearOne applied for a Directors & Officers (D&O) liability policy with National Union. As part of the process, ClearOne was required to complete an insurance application. One question asked applicants to provide copies of various documents or to indicate whether the documents are available on the Internet, including a 2002 10-K Form. See Question 14, Aplts. App. at 3680. ClearOne directed National Union to its website to obtain: (1) the "latest 10K report filed with the [SEC]"; (2) the "latest interim financial statement available"; and (3) "all registration statements filed with the SEC . . . within the last twelve months." Id. Furthermore, in response to other questions seeking a list of the applicant's executives, ClearOne responded, "See 10K." See Question 4(a) and (b), id. at 367778. In bold capital letters, the application declares, "All written statements and materials furnished to the insurer in conjunction with this application are hereby incorporated by reference into this application and made a part hereof." Id. at 3681.

The application also includes a severability clause. Provision 15 of the application states,

It is further agreed that in regard to the applicability of questions 8, 9, and 10 above,^(*) the facts pertaining to any knowledge possessed by any Insured (other than the knowledge and/or information possessed by the person(s) executing the application) shall not be imputed to any other Insured Person; only facts pertaining to and knowledge possessed by any past, present or future chairman of the board, president, chief executive officer [CEO], chief operating officer [COO], chief financial officer [CFO] and General Counsel . . . of the Organization shall be imputed to the Organization.

Id. at 3680 (emphasis added).

The application was signed by Frances Flood, the President and CEO of ClearOne, on behalf of the corporation. As part of the application, she warranted, "The undersigned authorized officer/manager of the applicant declares that the statements set forth herein are true." Id.

Upon receipt of the application, National Union undertook a review and analysis of the documents. National Union thoroughly examined the 10-K, the 10-Q, and other financial documents provided by ClearOne. After reviewing ClearOne's documents, National Union had additional questions about the financial statements. Brady Head, a Senior Vice President of National Union, emailed a ClearOne representative asking specifically if the company certified its financials as required by Sarbanes-Oxley and if there were any non-compliance issues with respect to its revenue recognition practices. Head received answers to those questions in a conference call with Susie Strohm, ClearOne's CFO, who indicated there were no non-compliance issues and the financials were certified. National Union issued a D&O policy to ClearOne valued at $3 million to run from October 29, 2002 until October 29, 2003.

In early 2003, ClearOne publicly acknowledged that its financial statements for the previous two years were not reliable, later admitting that shareholders' equity and net income had been substantially overstated.⁽²⁾ The overstatement arose from ClearOne's revenue recognition practices. ClearOne entered into distributor agreements with a policy of recognizing revenue when the product was shipped to distributors. It required distributor payments within 90 days, but the common practice was to permit distributors to remit payment for the products if and when the products were subsequently sold. This practice was known as "pay as you go" or "pay as you sell" and led to the accelerated recognition of revenue not yet received.

The admission of financial irregularities precipitated several shareholder suits and an investigation by the SEC. In anticipation of these matters, ClearOne notified National Union as a prelude to tendering a claim under the policy. In response, National Union announced its intention to rescind the insurance contract ab initio based on the 2002 financial misstatements, which it relied on in issuing the policy.

ClearOne later entered into a consent decree with the SEC, enjoining any future securities law violations without admitting any guilt. Based in part on National Union's refusal to honor the D&O policy, ClearOne also settled a class action suit by its shareholders, paying $5 million and issuing 1.2 million shares of common stock to the class plaintiffs.

1. Procedural History

ClearOne and Bagley brought this diversity action to enforce their rights under the $3 million D&O liability insurance policy. They each asserted a breach of contract claim and a tort claim based on bad faith, and both sought punitive damages. Bagley's claims specifically relate to the dilution of his ownership share based on the distribution of additional company shares as part of the settlement of the class action suit. He claims that the issuance of the 1.2 million shares of ClearOne stock diluted his ownership and effectively forced him to contribute a portion of his shares in the company to the settlement. National Union's principal defense is that it properly rescinded the policy after discovering it had issued the policy in reliance upon material misrepresentations made by ClearOne in its insurance application and related materials. Both sides filed cross motions for summary judgment and partial summary judgment. In granting summary judgment for National Union, the district court (1) held National Union properly rescinded the insurance policy in its entirety under Utah law, and (2) rejected Bagley's claims since he suffered his loss in the capacity of a shareholder and not as a ClearOne director. The court's rulings rendered moot the other summary judgment motions.
Both ClearOne and Bagley appeal the decision.II. Standard of Review
We review the district court's grant or denial of summary judgment de novo, applying the same legal standard that the district court applied. Montero v. Meyer, 13 F.3d 1444, 1446 (10th Cir. 1994). Under that standard, summary judgment is appropriate "if the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law." Fed. R. Civ. P. 56(c). "An issue of fact is 'genuine' if the evidence allows a reasonable jury to resolve the issue either way and is 'material' when it is essential to the proper disposition of the claim." Haynes v. Level 3 Communs., 456 F.3d 1215, 1219 (10th Cir. 2006) (internal quotation omitted). On an appeal from a motion for summary judgment, we construe all factual inferences in favor of the party against whom summary judgment was entered. NISH, Inc. v. Rumsfeld, 348 F.3d 1263, 1266 (10th Cir. 2003).
In addition, we review the district court's interpretation and determination of state law de novo. Freightquote.com v. Hartford Cas. Ins., 397 F.3d 888, 892 (10th Cir. 2005). "Where the state's highest court has not addressed the issue presented, the federal court must determine what decision the state court would make if faced with the same facts and issue." Oliveros v. Mitchell, 449 F.3d 1091, 1093 (10th Cir. 2006) (internal quotation omitted).