D&O Insurance Update
from
March/April 2006
by Randy Myers
How
well protected are you if something bad happens to your
company—criminal charges that bring in the Department of Justice, say,
or restated earnings that attract the attention of the plaintiffs’ bar?
Prudent board members should always know the exact extent of their
directors’ and officers’ insurance: what it covers, what it doesn’t,
and where they rank in the pecking order if judgments against their
company or board threaten to exceed the total value of the policy.
Historically, directors felt secure knowing they were backed by the two traditional components of D&O insurance, Side A and Side B coverage. Side A pays them directly for any penalties they might incur, including legal costs, when corporate indemnification is unavailable. Side B reimburses the company for any payouts it makes on behalf of its officers and directors. But there are some new trends in D&O that directors should be aware of. Among them:
Side A “difference in conditions” policies
One
of the most popular new D&O products, this supplemental Side A
policy kicks in when the company is financially unable to indemnify its
officers or directors—an outfit in bankruptcy might not have the cash,
for example—or when the company’s primary D&O policy doesn’t cover
a particular event. Cases involving pollution are typically excluded
from D&O policies, says John Rafferty, vice president in charge of
D&O underwriting at Hartford Financial Products, a unit of the
Hartford Financial Services Group. Difference in conditions (DIC) also
covers a director or officer if the insurance company rescinds the
primary policy, something it might do if it felt it was misled when it
wrote the coverage, for instance.
This supplemental
coverage isn’t a bad idea, says attorney Tim Burns, a partner at Neal
Gerber & Eisenberg LLP in Chicago and co-chair of the insurance
coverage litigation committee of the American Bar Association. But he
warns against buying too much at the expense of traditional D&O
insurance, which, he says, “has the benefit of protecting both the
organization and the directors and officers.” In addition, says Burns,
“DIC policies protect only the directors and officers. Unless the
corporation is seriously insolvent [in Chapter 7 liquidation rather
than the much more common Chapter 11 protection against creditors], it
is very unlikely that anyone will ever use them.”
Severability
It’s
hard to buy D&O insurance these days without having somebody advise
you to make sure it includes severability, a legal term that can mean
that even if one portion of an insurance contract is deemed
unenforceable, the rest of the coverage stays in force. In other words,
directors and officers are insured individually and not as a group.
Severability can come into play in a D&O policy if, say, one of
your fellow officers or directors commits fraud and his or her actions
trigger a lawsuit. Under most policies without severability, the
insurer could deny any claims resulting from such actions. That would
leave you unprotected if shareholders were suing the company as well as
all its directors and officers. Severability provisions keep you
covered even though your unscrupulous colleague isn’t.
But
you’re still not out of danger. There’s a risk that if the case goes
badly, the company might use up all the coverage, leaving you and your
fellow innocents on the board or in the executive ranks without
protection.
One possible solution, says Mike Early,
assistant general counsel for insurer Old Republic International
Corp.’s Chicago Underwriting Group, is to see that the severability
language lays the responsibility for the bad actors on the company
itself. That will prevent the company from consuming the policy’s
benefits and preserve them for you. Such language is often referred to
as “partial” or “limited” severability as opposed to “full”
severability.
Final adjudication
Some
D&O policies require final judgment of a lawsuit before the insurer
can invoke a fraud exclusion that lets it deny coverage. But by then a
crooked colleague could well have racked up significant costs before
heading off to jail, eating into the coverage you thought you had. To
avoid this, Early says, policies can be written so that honest officers
and directors can work with their insurance carrier to cut off payments
to dishonest ones before any final resolution of a case and use the
proceeds to protect the innocent. An admission of guilt is one clear
example of when this should happen.
Investigative costs
Most
D&O policies don’t cover the expenses a company might incur in
responding to or defending against a Securities and Exchange Commission
investigation. That coverage starts only after the SEC enforcement
staff goes before the commission and seeks a formal order of
investigation. But companies can spend substantial sums responding to
even an informal SEC inquiry, long before it gets to official status.
As a result, Tim Burns says, some companies have been looking to get
such coverage included in their policies.
To date,
insurers have been extremely reluctant to provide it—and that’s
probably to the benefit of directors and officers anyway, says
Hartford’s John Rafferty, because it guards against the premature
depletion of the assets of a policy that may be needed later for
individual officers and directors. “If you start depleting the D&O
liability program for an informal inquiry that hasn’t yet targeted any
directors or officers, you would again be depleting the D&O
insurance proceeds,” he says. Early agrees: “One should not fall into
the trap of thinking something provides more coverage when, in essence,
it can result in less coverage for officers and directors.”
You
might get around this problem simply by buying more insurance. But that
can be difficult in “hard” insurance markets, when insurers are able to
command high premiums. And for some large companies, there may not be
enough capacity in the D&O marketplace to provide all the coverage
they might want or need in the case of a mega-settlement. In other
words, just say no to insuring against investigative costs.
Side C coverage
Also
known as entity coverage, Side C reimburses the company directly for
anything it has spent defending securities lawsuits. As many as 90% of
public companies may now have this coverage, according to some
estimates.
If it seems odd to you that part of the
premium for your D&O policy goes to providing protection for your
company and not you, you’re paying attention. That’s why not everybody
favors Side C. In fact, Early notes that some Fortune 500 companies now
forgo both Side B and Side C coverage and buy Side A policies only.
“It’s a problem of erosion,” he explains. “If you have the C coverage
going to the corporation under certain circumstances, you could have
complete exhaustion of your coverage, leaving nothing to protect the
officers and directors.”
A fundamental issue in deciding what types of coverage to purchase, says Early, is choosing what you want to protect: the corporate balance sheet or the directors and officers. Ultimately, he suggests, providing solid protection for the directors and officers will go a long way toward safeguarding the company and its shareholders too. A company needs the right mix of traditional D&O and Side A DIC coverage and limited severability, but probably no pre-formal-investigation coverage and, depending on the circumstances, maybe no Side C insurance. That array of protection should attract the savvy directors the company needs to best look after shareholder interests.
