Where Directors Are at Risk
from Winter 1998
by Sara Harty
Board members may want to add one more item to their “to do” lists: Check on the status of their D&O insurance coverage. Such policies take care of all kinds of liabilities for corporate directors and officers, ranging from sexual harassment to costs stemming from SEC investigations. But two hot areas of concern in particular may leave directors inadequately protected:
- A company’s preparedness for year 2000 computer problems, and
- Employment discrimination.
Coupled together, in fact, these two could even leave a director in the possibly ruinous situation of having no coverage at all.
For Ty Sagalow, New York-based chief underwriting officer for AIG’s National Union Fire Insurance Co. of Pittsburgh, “the millennium bug is the greatest potential exposure for directors today.” According to Vito C. Perains at Hancock Rothert Bunshoft, a San Francisco law firm, that exposure is already evident in the more than 20 lawsuits filed against Intuit, Symantec, and other software manufacturers. Produce Palace International, a fruit and vegetable store, brought the first such suit in Michigan. It alleged a cash register system purchased from Tec-America repeatedly crashed when credit cards with an 00 expiration date were used. The parties settled for $260,000.
Typically, the defendants in these suits are corporations, and so far no suit has cited negligence by individuals. But Sagalow, among others, thinks that will soon change. “Almost everyone connected with D&O believes that directors and officers will be named in suits before the problem is over,” he says. Adds Christopher J. Cavallaro, managing director and one of the founders of ARC, a wholesale D&O broker in Mineola, Long Island: “Year 2000 is a tremendous generator of new claims, though whether we’ll have Armageddon, I don’t know.”
Phillip N. Norton, Chicago-based managing director of Sedgwick First, a financial risk specialist firm in Memphis, not only expects that Y2K claims will be increasing significantly but also warns that shareholders could come at directors from opposite directions. “Some will be suing a company that said it had the problem under control when it didn’t,” he predicts. “Others will be suing directors for spending too much money on year 2000 problems that never materialized.”
Lou Ann Layton, managing director of J&H Marsh & McLennan in New York City, cites another potential liability stemming from Y2K. She says even though most of her clients, Fortune 500 companies in the main, will be prepared, “their bigger concern is that their vendors won’t be, and their failure will somehow impact on the company’s business.” Clearly, if vendor problems prove contagious to a company’s business or stock price, directors could be blamed.
The SEC, of course, requires all publicly held corporations to disclose in such documents as their 10Qs and annual reports what they are doing to prepare for Y2K. But they do so with varying degrees of obfuscation. A good disclosure not only tells you what a company will be doing to get ready for year 2000, but gives deadlines for each of the steps it will be taking. Directors should protect themselves by pushing for such clarity.
So where does all this leave the director? Some argue that because standard D&O policies don’t specifically exclude Y2K issues, directors are covered. Others argue that the coverage should be spelled out via a policy that offers specific protection. To that end, Sagalow’s National Union rolled out a D&O Gold policy earlier this year that includes millennium exposures in its package of coverages. Other insurers offer similar coverage by way of tailor-made policies. Are directors biting? Sagalow says about one-third of his company’s clients have switched to the new package as they renew their insurance.
While they’re running through their checklists, directors also ought to look at possible gaps in their D&O insurance covering the costs they might incur in the early stages of any official investigation into their company. Legal costs begin to accumulate the moment a director, say, receives a subpoena or becomes involved in grand jury hearings. Coverage for such investigations is widely available, but it is not automatically included under every D&O policy, explains Sagalow.
There’s good news and bad news about sexual harassment cases. Surprisingly, given the Clinton scandal, experts don’t predict that the actual number of cases brought against directors is likely to increase in any significant way. For this, thank U.S. Supreme Court Justice Clarence Thomas. Explains Norton: “His confirmation hearings raised awareness to such an extent that recent events won’t have much more of an impact.” But while the number of cases may have plateaued, the results of recent suits are still cause for concern. The Civil Rights Act of 1991 provided for punitive damages in sexual harassment cases and allowed for a trial by jury instead of a judge, two factors that have led to dramatically larger awards.
More threatening, that same 1991 law puts directors at another kind of risk—one for which they may have no coverage at all. Lawyers are bringing an increased number of class action employee practices liability (EPL) cases against corporations, suits that typically cite discrimination. Once the plaintiffs win that case, they, or others, can then launch a personal suit against a director.
These chinks in the armor could cost directors dearly. Since some policies combine the maximum limits for both EPL and D&O claims, the expenses incurred in defending an EPL case may leave nothing to fight a subsequent D&O claim. And that’s not all. According to Norton, “The horror of it is not only that directors don’t have insurance, but if a D&O suit is derived out of an EPL suit, it is not indemnifiable, because it is a derivative lawsuit. You as a director are financially ruined—no limits left and the corporation is legally banned from indemnifying you,” adds Norton. The solution: Directors of public companies should make sure that they have separate EPL and D&O limits.
D&O insurance has been a buyer’s market in recent years, though opinions differ on how long this will last. Says Norton: “D&O policies are still offering a good value. Even with some pretty attractive enhancements, prices are stable.” In other words, average prices are actually falling. “People think the D&O market is flat, but it is not flat if there are several coverage options that they are getting for free,” Norton says. “It would be like if I offered you a car for the same price you paid last year, but this time I threw in air conditioning and power steering and a CD player.”
Looking ahead, ARC’s Cavallaro is less optimistic: “The claims count is up 60% in the last year, rates are down 50% over the last five years, and coverage is twice as broad as in the last five years. There’s been a tremendous increase in claims, and that will continue.” As a result, Cavallaro sees “cracks in the foundation. Prices are bound to go up, probably somewhere in the first quarter of 1999.” Keith M. Thomas, assistant vice president in New York with Zurich American’s executive assurance division, also thinks rates may increase, but he expects only minimal hikes. “There is a huge amount of capacity available. But the tremendous amount of competition among insurers means the increase will not be dramatic.”
Ultimately, the extent of any rate increases will depend on the outcome of a huge backlog of unsettled claims. Many are sitting with National Union and Chubb and Son, the two giants of the industry, while the rest are interspersed among the many new insurers who glut the D&O industry. Much of the responsibility for the backlog lies with the 1995 Private Securities Litigation Reform Act. Designed to cut back on frivolous suits, the law actually brought about a huge increase in claims because many believed the size of awards would be much greater. The number and size of claims involving discrimination, though not covered by the new law, also increased.
Among others, Jack Kuhn, vice president of Chubb in Warren, N.J., believes that the size of D&O claim settlements is likely to increase and that higher premiums are sure to follow. This is bound to catch the eye of the corporate bean counters, who will be tempted to cut costs. Directors need to be watchful that their limits for D&O liability aren’t dangerously downsized.
