The fallout from the collapse of major U.S. companies as a result of governance scandals spreads far and wide. Not surprisingly, one of the issues that immediately arose when these scandals broke was whether director and officer liability (D&O) insurance covered the officers, directors and the corporations themselves. Perhaps even more important, however, is the continuing impact of these and other cases on the D&O insurance market as a whole. While Enron and Tyco are some of the more high-profile cases, they are certainly not alone. Other significant D&O settlements in the last five years have included Cendant Corporation (approximately $3.2 billion); and Waste Management (a combined $677 million).
Companies now seeking to obtain or renew D&O coverage are increasingly facing a "hard" D&O insurance market. Insurance companies, which are facing numerous, substantial claims, have significantly tightened their underwriting and claims handling. For example, when seeking D&O coverage, insureds now face higher premiums, higher deductibles and more restrictions on coverage. This market situation also is resulting in disputes over coverage and in questions about misrepresentations leading to possible policy rescission. Moreover, the more frequent litigation of D&O insurance coverage issues has increased the body of law interpreting many key policy provisions.
As a result, it is now more important than ever for companies, officers and directors to ensure that they have appropriate and sufficient D&O coverage in place. The natural question then becomes, how do we know what constitutes appropriate and sufficient coverage for our company? Because each company is different, the answer to that question is that a careful, objective analysis should be performed to determine the needs of that particular entity.
Analyzing Your D&O Coverage
An objective D&O coverage analysis must consider a variety of different factors. To begin, however, three general questions should be asked:
These questions are often difficult to answer. A number of important policy terms should be carefully considered in making those determinations. Some (but by no means all) of the most important terms are described briefly below.
While it may seem obvious, it is vitally important to make sure that there are no gaps in the coverage periods. Too much is at stake for an officer or director to discover that they are uninsured because of a lapsed policy, a gap between coverage periods, or the failure to purchase "tail" coverage when necessary.
Who Is Covered
A company needs to determine who currently is, and who needs to be, covered by the D&O policy. Obviously, internal directors and officers are covered. But what about outside directors? The company's general counsel? Other employees who may be exposed to certain claims? In many cases, a company may determine that persons other than internal directors and officers need to be covered. If so, the company's D&O policy must be modified to ensure such coverage exists.
What Claims Are Covered
Once a company knows the "when" and the "who," it must then determine the "what." That is, what types of claims does the D&O policy need to cover? Generally, D&O policies provide three types of insurance coverage. Side A or Executive Liability Coverage provides reimbursement to individual directors and officers for losses incurred from their alleged wrongful acts that are not indemnified by the company. Side B or Corporate Reimbursement Coverage provides reimbursement to the company for expenses arising from the indemnification of directors and officers. Finally, Side C or Entity Coverage provides coverage for certain limited claims made directly against the company, such as securities claims, due to the company's own wrongful acts and liabilities. The terms and conditions of each of these coverages can vary greatly, and many D&O insurers only provide Entity Coverage at a significant increase in premium. D&O policies typically define a loss as any damages, judgments, settlements and defense costs incurred as a result of a claim against an insured covered by the policy.
Limits of Liability
Coverage under a D&O policy is subject to an aggregate limit of liability that imposes a maximum amount payable by the insurer for all losses arising under the policy. Due to the recent increase in the number of lawsuits filed against corporate officers and directors and the uncertainty of settlement costs and jury awards, companies should carefully consider the appropriate policy limits necessary to ensure adequate D&O coverage in their particular business field.
Coverage also is subject to varying retention amounts that require the insured to retain a portion of liability under the policy. While the retention for Side A coverage is generally zero, D&O policies often set substantial retention amounts for Side B and Side C coverage. Unlike the limit of liability that applies to the entire loss, the retention applies separately to each claim made against the insured. Most D&O policies, however, consider multiple claims arising from a common wrongful act or series of wrongful acts as a single claim subject to only one retention.
Unlike other types of insurance, D&O policies generally do not impose upon the insurer the duty to defend the insured. Instead, the policies provide for reimbursement of defense costs, sometimes only following judgment or settlement of a claim. Alternatively, many policies require the insurer to "advance" defense costs, at least to individual directors and officers, but the insurer can seek the return of those funds if the claim is ultimately found not to be covered by the policy. Defense costs generally are subject to the policy's aggregate limits of liability. Therefore, in cases involving lengthy or highly contested litigation, defense costs alone may exhaust a policy's limits, leaving the company or its individual directors and officers responsible for the final costs of settlement or judgment.
D&O policies set forth specific requirements for giving notice of a claim that are usually enforced by the courts strictly and failure to provide sufficient notice precludes coverage under a policy. Furthermore, an insurer is not required to demonstrate that it suffered any actual prejudice as a result of the insured's failure to give proper notice before denying coverage for the claim. D&O policies almost always are "claims made" policies, providing coverage for claims asserted against the insured during the term of the policy even if the alleged injury occurred years before the policy took effect. Additionally, some D&O policies require that a claim not only be made but also reported to the insurer during the policy term in order for coverage to apply. This distinction can be crucial, and the relevant policy language must be scrutinized on a case-by-case basis.
Insureds must be cognizant of the myriad policy exclusions that limit coverage. Exclusions for fraud, willful violation of the law and improper personal profit typically apply only if such conduct is established by final adjudication. But insurers in recent years have sought to water down this protection for insureds. Other exclusions include those for bodily injury and property damage losses, "insured versus insured" claims and claims related to prior or pending litigation at the time the policy went into effect. While all D&O policies contain some version of these exclusions, the scope and language of the exclusions can vary significantly.
Severability, whether the alleged intentional wrongdoing or false statements of a director or officer can be imputed to others to deny coverage, is often a crucial issue. Insureds should insist on policy provisions establishing the severability of certain conduct, such as statements made on the policy application and wrongful acts that may fall within policy exclusions for intentional conduct.
Allocation, a determination of what portion of defense costs, settlements or judgments are allocated to covered claims and what portion are allocated to uninsured claims, is often a significant issue in D&O claims handling. D&O policies sometimes contain a predetermined allocation formula, or a list of factors for determining the proper allocation. Other policies remain silent on this issue, which may be the reason why insurers and policyholders litigated a large number of allocation disputes in recent years.
Mergers and Acquisitions
Corporate mergers and acquisitions typically alter the insured's liability exposure, thereby changing the insured's D&O insurance needs. D&O policies often cover a new subsidiary if its value or size is below a certain threshold, while larger acquisitions will require notice to the insurer and an additional premium for coverage to exist. If it is the insured company that is acquired, coverage may only exist for claims alleging wrongful acts prior to the acquisition. Some policies allow the company to cancel the policy at any time, while others prohibit cancellation if the company is acquired in order to protect former directors and officers. As a general rule, companies, directors and officers should conduct a review of their D&O coverage whenever a merger or acquisition is contemplated.
Potential Bankruptcy Issues
The treatment of D&O policies in bankruptcy is a highly disputed, and often litigated, issue. Disputes arise over whether the D&O policy and the proceeds thereof are property of the bankruptcy estate and, therefore, are for the benefit of all creditors, or whether the proceeds are available only to the insureds. A related issue is whether the automatic stay imposed by the bankruptcy proceeding limits the actions of insurers and insureds, alike. Disputes also arise in the context of the "insured versus insured" exclusion, and whether such an exclusion bars coverage where the bankruptcy trustee or some other estate representative brings a cause of action against the debtor's directors or officers. These issues have far reaching implications for insurers and insureds, affecting the advance of defense costs, entitlement to proceeds and, in some cases, coverage itself. The manner in which the policy is structured, such as whether the policy provides for entity coverage, may dictate how the policy will be treated in bankruptcy.
The Benefits of an Independent D&O Insurance Review
Purchasing and maintaining the insurance protection that directors and officers require has become increasingly difficult in the present climate. The insurance markets are reacting to this climate by revising policy forms, reducing or eliminating coverage and raising premiums. Maintaining adequate coverage requires a thorough understanding of the tradeoffs between coverage and cost. An independent review by counsel of your company's D&O exposures and coverage, when combined with the advice of an established insurance broker and your own internal risk management assessment, can inform the company's insurance purchases and help avoid unpleasant surprises should a claim arise.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.