By Gregg L. Weiner and Frédérique Beky
The current economic downturn and the increased frequency and severity of claims against directors and officers that will likely ensue make it more crucial than ever for directors to take a close look at their company’s Directors and Officers (D&O) insurance coverage and ensure that appropriate coverage is in place. While no one expects that D&O insurance will protect against any and all risks, directors legitimately expect that they will be protected from potential liabilities arising from the good-faith performance of their duties as board members. Too often, however, that legitimate expectation is disappointed due to important features of the D&O insurance program that did not receive adequate attention. The list below will help directors avoid being placed in that situation.
1. Focus on the ‘D’ in D&O
A typical D&O policy has several coverage components, usually referred to as A, B, and C. Side A provides coverage for claims against individual directors and officers, when the company legally is not permitted or unable to indemnify them. When the company provides indemnification to its directors and officers, it can seek reimbursement under Side B of the policy. Finally, Side C provides “entity” coverage to the company for certain asserted claims against it (mainly, securities law claims). This means that, in addition to the “Ds” and the “Os”, a policy typically provides coverage for the company itself. In some instances, the list of insureds can be even longer, and a policy may afford coverage to spouses as well as certain employees. This is important because, under traditional D&O coverage, all insureds—including outside directors, officers, and the company itself—share the policy’s limits. As a consequence, the available coverage can be severely depleted before a claim against the policy is even made by a director. This scenario is starkly illustrated by the fate of the outside directors of Just For Feet, a company that filed for bankruptcy protection in 2000. Around the same time it filed for bankruptcy, Just For Feet settled a class-action lawsuit brought against it and its directors and officers for $24.5 million, payment of which left only $100,000 available under the company’s D&O policy. As a result, when the bankruptcy trustee later brought suit against certain former outside directors, there was no money left to cover the $41 million settlement that put an end to the lawsuit. The fate of the directors and officers of automotive parts supplier Collins & Aikman is another dramatic case-in-point. There, the $50-million limit available under the D&O policy was entirely exhausted by defense expenses incurred in connection with the company’s bankruptcy and the related lawsuits and investigations, before trial in the criminal case even started.
One way the insurance market has responded to the risks posed by shared limits is by offering dedicated or “stand-alone” policies that protect only directors and officers or, even more narrowly, only independent directors or certain named individuals. These policies, sometimes referred to as “Side-A Only” or “Difference-In-Conditions,” vary greatly in their terms and scope. What they have in common is that they cannot be drawn upon by the company. Thus, while a director-only policy may not have been enough to fully fund the Just For Feet settlement given its magnitude, it would have gone a long way toward protecting the personal assets of directors and officers. Similarly, a supplemental dedicated policy could have offered protection to the individual Collins & Aikman directors and officers in the face of rapid exhaustion of the main policy’s limits due to the large number of “insured persons” with access to the policy.
2. Ask about severability
Another consequence of increased claim frequency as a result of the economic crisis is closer scrutiny given by carriers to claims made under the policy. This scrutiny may well focus on statements made as part of the insurance application process. Before an insurer issues a policy, the potential insured must submit an application. Among other information, the application typically includes the company’s financial statements, and representations by the CEO or CFO that there are no facts or circumstances of which he or she is aware that might give rise to a future claim covered under the proposed policy. If the financials or the representations and warranties turn out to be erroneous, the insurer can seek to rescind the entire policy, leaving all directors and officers without any coverage, whether or not they knew of the fraud or made the false representation.
Coverage rescission is thankfully rare. But it is a draconian result for the innocent individuals covered under the policy, and it is a remedy that D&O insurers have sought or obtained in several high profile cases—think Tyco, Healthsouth, or Worldcom. To protect against the risk of rescission, the application (or the policy itself) should contain a so-called “severability” clause. Severability language protects the innocent directors by ensuring that an insurer can rescind coverage only as to an insured with actual knowledge of the misstated facts and precludes the carrier from imputing the knowledge of one insured to other insureds.
3. Insulate innocent directors from the impact of misconduct by others
Severability is also key with regard to a policy’s exclusions. D&O policies generally exclude from coverage claims arising out of criminal or fraudulent acts and acts involving illegal profit or personal advantage. Without language limiting the scope of these “conduct” exclusions, a director could be denied coverage based on a plaintiff’s allegations, a carrier’s self-serving assertions of misconduct by a director, or another insured’s fraudulent acts.
To avoid this outcome, the policy should provide that, with regard to policy exclusions, the conduct of one individual insured will not be “imputed” to any other insured. This ensures that an individual insured will not be tagged with a bad actor’s wrongdoing. In drafting the clause, it is essential to consider the policy as a whole and to be mindful of its interplay with the other policies that form the coverage program. This is one of the lessons to draw from a recent decision arising out of the ill-fated 2005 Refco IPO. The Southern District of New York found that a primary policy’s severability-of-exclusions language applied only to the exclusions in the primary policy, and not to the excess policies, despite their so-called “follow-form” nature. (A “follow-form” policy incorporates the terms and conditions of the primary policy, subject to expressly stated non-conforming terms.) As a result, coverage under the excess policies was barred as to all insureds because of the misrepresentations of the company’s CEO, which triggered the policies’ knowledge exclusion precluding coverage for claims arising from any facts or circumstances that might be reasonably expected to give rise to a claim of which any insured had knowledge at policy inception.
A further way to limit the potential impact of the conduct exclusions is to spell out clearly the standard to be used to determine whether misconduct by an insured has occurred. A mere finding by the insurer of misconduct “in fact,” a written admission of misconduct by an insured, or a plaintiff’s allegations in a complaint should not be enough to trigger the exclusion. Instead, the policy should contain language providing that, before coverage can be denied under the exclusion, there must be a final adjudication in the underlying action adverse to the director that such bad conduct indeed occurred. Given the fact that most disputes settle before trial, the “final adjudication” language typically prevents the exclusion from being used to deny coverage.
4. Understand the effects of bankruptcy
Although the year is still young, 2009 is well on the way to be a record year for corporate bankruptcies. Recently released data shows bankruptcies for publicly traded companies already at twice their 2008 level. This trend not only increases the likelihood of claims against the directors and officers of the bankrupt companies, it also means that the availability of coverage could be threatened should one of the carriers become insolvent.
To make matters worse, courts routinely freeze D&O policies as being part of the bankruptcy estate, when the policy includes entity (Side C) coverage. This leaves directors and officers temporarily—if not permanently—without access to the policy’s proceeds. Dedicated policies of the type discussed above—policies that cover only the directors and officers, not the entity—help alleviate these concerns by providing limits that are available to the directors in case of insolvency of the company, when the need for coverage is most acute. They also provide coverage in the event one of the carriers of the traditional D&O program becomes “financially unable” to respond to the claim. (Of course, this is only true if the stand-alone policy’s carrier is not the carrier on the traditional D&O side.)
Another potential coverage gap exacerbated by bankruptcy is a consequence of the “insured-versus-insured” exclusion. The “I v. I” exclusion, which is a feature of every D&O policy, provides that a claim brought by one insured against another insured will not be covered. The exclusion was originally crafted to prevent collusive claims by insureds. An unintended result is that a bankruptcy trustee standing “in the shoes” of the company could be considered an insured under the policy, and claims brought by the trustee against the company’s directors and officers barred from coverage under the exclusion. It is therefore crucial to limit the scope of the I v. I exclusion by explicitly
5. Know what constitutes a ‘claim’
The credit crisis has caused a marked increase in regulatory investigations and administrative enforcement actions. The availability of coverage for administrative and regulatory investigations depends on the particular language in the applicable policy, most notably the policy’s definition of the term “claim.” For example, it is not uncommon for policies to limit coverage for civil administrative proceedings to expenses incurred after the entry of a formal order and, for criminal proceedings, to post-indictment matters. However, considerable expenses are incurred by a company in the early stages of an investigation, precisely in order to avoid the entry of a formal order or an indictment. Directors should ensure that the policy’s definition of “claim” is broad enough to include informal investigations from the time a subpoena is received (or, somewhat less favorably, from the time an insured is identified in writing as a person against whom charges may be filed).
6. Don’t ignore the excess
Most D&O insurance programs involve multiple coverage layers. The first policy in line, the primary policy, might cover $10 or $20 million. Excess policies provide additional limits of liability in excess of a specified underlying amount of coverage. One important feature of all excess policies is that they come into play only after the underlying policy is “exhausted,” i.e., fully paid out. The exhaustion clause of the excess policy, which governs when an excess insurer is obligated to pay, is therefore critical. In a recent case, Qualcomm, incurred close to $30 million in defense and settlement expenses in connection with a series of lawsuits related to the company’s stock-option granting practices. The company agreed that its primary insurer (whose coverage limit was $20 million) would pay $16 million toward the settlement in exchange for a full release for any future claim under the policy. When Qualcomm turned to its excess carrier, Lloyd’s of London, for coverage, Lloyd’s refused to pay, arguing that the underlying layer had not been “exhausted” because payments by the primary were $4 million short of its limit. Based on the particular language of the policy, the court agreed that the excess layer had not been triggered.
The lesson here is that excess policies should provide that underlying coverage will be deemed exhausted if either the underlying carrier or the insured pays the loss. Such a provision will make it easier for a company to negotiate a settlement with a carrier without fearing the loss of its excess coverage. It will also provide protection should an underlying carrier become insolvent.
7. Make sure the company has adequate claim-reporting procedures
It should be apparent by now that the time to think about D&O coverage is long before a claim presents itself. Now is the time to locate and review all liability policies that may provide coverage in case of a claim. While this discussion has focused on D&O insurance, a claim against a director may potentially trigger coverage under more than one line of insurance. For example, claims arising out of allegations of negligent or reckless misrepresentations about a company’s investment activities or failures to perform adequate due diligence would likely also be covered under professional liability errors and omissions (E&O) insurance policies, which are designed to cover losses arising from alleged wrongful acts committed in rendering or failing to render professional services. The sections of the policies that relate to notice merit special attention. Timely notice of claims is critical to ensure coverage. Most E&O and D&O policies are claims-made policies, meaning that the claim must be made during the policy period. Some policies have a “notice of circumstances” provision, which require that a company give notice of facts or circumstances that potentially could give rise to a claim. It is important to make sure that the company has procedures in place to ensure timely reporting of potentially covered claims and circumstances. In reviewing such procedures, one should consider the interplay between the notice provisions and the policy’s definition of a “claim.” An expansive definition of claim means that more situations will trigger the notice requirement.
8. Last but not least: review the company’s indemnification policy
With recent events causing renewed interest in D&O insurance, it is easy to forget that the first line of defense for a company’s directors and officers is corporate indemnification. All companies include within their certificate of incorporation, bylaws, or charter indemnification provisions that require the company to indemnify its directors and officers under certain circumstances. These provisions should be closely analyzed to ensure that they are state-of-the art in light of statutory law and latest court decisions, as well as other legal developments. For example, a Delaware court held last year that a former director was not entitled to advancement of his legal fees where, subsequent to the director’s departure from the board, the company revised its bylaws to eliminate advancement rights for former directors. To avoid the same fate, a director should ensure that, when indemnification is provided under a company’s bylaws, the bylaws include language stating that the rights to indemnification are contractual, vest upon commencement of board service, and cannot be limited by a retroactive amendment of the bylaws. It may also be appropriate to consider the purchase of a dedicated policy for retired directors.
The expected increase in D&O claims makes it more important than ever to carefully review policy language and to be aware that seemingly minor wording nuances can mean the difference between having and not having coverage. Because the language of D&O policies presents unique complexities, enlisting the assistance of a knowledgeable insurance expert will help directors gain a thorough understanding of the coverage available to them under their company’s D&O insurance program.
Sources: Settlement in Just for Feet Case May Fan Board Fears, The Wall Street Journal, April 23, 2007: http://online.wsj.com/article/SB117728671802378484.html?mod=todays_us_marketplace
Various orders and pleadings, including the Motion for Appointment of Counsel Under the Criminal Justice Act, U.S. v. Barnaba, 07 CR 0220, SDNY Aug. 18, 2008: http://www.law.du.edu/index.php/corporate-governance/criminal-cases/united-states-v-david-stockman
XL Specialty Insurance Company v. Agoglia, et al., No. 08 Civ. 3821 (S.D.N.Y. March 2, 2009). U.S. Bankruptcies Double 2008 Pace, Reuters, March 10, 2009: http://www.reuters.com/article/ousiv/idUSTRE52960S20090310
Qualcomm, Inc. v. Certain Underwriters At Lloyd’s, London, 161 Cal. App. 4th 184, 73 Cal. Rptr. 3d 770 (Cal. Ct. App. 2008). Schoon v. Troy Corp., C.A. No. 2362, 2008 WL 821666 (Del. Ch. March 28, 2008).
Gregg L. Weiner (gregg.weiner@friedfrank.com) is a litigation partner and Frédérique Beky (frederique.beky@friedfrank.com) is a litigation associate at Fried, Frank, Harris, Shriver & Jacobson LLP.