ABA Section of Business Law

ABA Section of Business Law
Business Law Today
September/October 1999

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The armor-plated board

Yes, D&O coverage needs to be negotiated

By CAROLYN H. ROSENBERG and DUANE F. SIGELKO

Rosenberg and Sigelko are partners at Sachnoff & Weaver, Ltd. in Chicago.

• Special coverages
• What about bankruptcy?

Everything seemed under control. The board members didn’t even think much about their personal liability. Then came the lawsuit that named them by name. Could the problem be yours?

According to a 1998 Directors and Officers Liability Survey by Tillinghast-Towers Perrin (the 1998 Survey), the largest percentage of reported claims against corporations and their directors and officers are employment-related. Claims by shareholders are second, followed by claims by customers and clients, competitors, other third parties and government agencies. The survey also found that where a policyholder was indemnified in cases that had been closed during the previous year, the average claim was $3.26 million.

Given the potential exposure and cost of claims, action must be taken to protect directors and officers, including the review or purchase of directors’ and officers’ liability (D&O) insurance. This article explains key provisions of that insurance as well as coverage options in the marketplace.

D&O insurance is an asset of the corporation and its directors and officers. The coverage is intended to protect directors and officers from personal loss and reimburse the company for payments made to indemnify them. The corporation may also be an insured for direct claims made against it if "entity" coverage is purchased.

Companies may buy D&O insurance for a variety of reasons.

Indemnification may be insufficient protection if a company has assets that may not be adequate to allow the corporation to easily satisfy its indemnification obligations. Insurance coverage may also be available in some situations where a director or officer does not meet a standard of "good faith" required for indemnification by the corporation (such as where conduct was opposed to the best interests of the corporation but not intentionally dishonest and thus excluded by the D&O policy). There may also be restrictions on the corporation’s ability to indemnify directors and officers in some jurisdictions for derivative judgments and settlements.

Compare TLC Beatrice Int’l Holdings Inc. v. CIGNA Insurance Co., No. 97 Civ. 8589, 1999 U.S. Dist. LEXIS 605, at *10-12 (S.D.N.Y. Jan. 27, 1999) (corporation cannot under Delaware law indemnify its directors and officers for settlement of a derivative action but can indemnify them for defense costs and fees) with Heffernan v. Pacific Dunlop GNB Corp. , No. 91 C 2494, 1993 WL 3553, at *5 (N.D. Ill. Jan. 5, 1993) (a corporation’s indemnification of settlement amounts in a derivative action, without court action, is not prohibited under Delaware law).

In some circumstances (for example, a healthy corporation with strong indemnification provisions and a low risk of claims), corporations may opt not to purchase D&O insurance or to only buy direct coverage for directors and officers where the corporation cannot or does not indemnify its directors and officers.

This direct coverage for directors and officers is often referred to as "Side A" or "last resort" coverage. It is usually much cheaper than traditional D&O insurance because it only comes into play when the corporation cannot (because of insolvency or the failure to meet a standard of care, for example), or does not, indemnify the directors and officers. This is a relatively infrequent occurrence, usually arising where there has been a dispute regarding corporate control.

Given the severity and expense of potential claims, however, many companies, especially public corporations, purchase traditional D&O insurance to cover not only unindemnified claims made against the directors and officers but also to reimburse the company for its costs in providing indemnification. Under this corporate reimbursement, or "Side B" coverage, the insurer agrees to "pay on behalf of" or "reimburse" the corporation for amounts the corporation has paid or is required to pay in indemnifying its directors and officers.

In recent years, limited forms of "entity" coverage under D&O policies also have become popular. Under these provisions, certain claims against the corporation — usually securities or employment-practices liability claims — also are covered. Entity coverages may be very valuable if they can be obtained for a reasonable premium.

D&O insurance typically covers "loss" arising from claims made against directors and officers (or in some instances against the company or employees) for negligent, rather than intentionally dishonest, conduct causing economic injury. A typical definition of "wrongful act" is "any breach of duty, neglect, error, misstatement, misleading statement, omission or act by the directors or officers in their respective capacities as such, or any matter claimed against them solely by reason of their status as directors or officers of the company." (American International Companies Directors, Officer and Corporate Liability Insurance Policy, Form 62334 (5/95), Section 2(m).)

Some policies restrict the coverage to claims against directors and officers who are alleged to have been acting "solely" in their capacities as directors and officers. This language may spark a coverage challenge where a director is sued in a dual capacity as both selling shareholder and director or serves as both a director and outside counsel, for example. To avoid this dispute, insureds should seek to delete the word "solely" from such a definition when negotiating coverage.

A D&O policy traditionally defined insureds to be only directors and officers elected or appointed to such positions in accordance with a company’s by-laws or certificate of incorporation. Thus, D&O policies did not cover loss resulting from claims made only against the corporation, at least in situations where the claims are not based on allegedly wrongful acts of directors or officers.

Where "entity" coverage is offered, it is provided for claims against the corporation although it may be limited to securities claims or employment-related claims. Insurers also may extend coverage to employees generally, which may eliminate an argument that there should be an allocation of loss where directors and officers and a nonofficer are sued; the nonofficer, if an employee, is covered.

Companies should carefully review the definitions of "insureds" or "insured persons" in conjunction with their corporate-governance documents to ensure that they are acquiring coverage for all persons for whom coverage is desired, even if such persons are not technically officers and directors. In addition, a number of insurers will cover managers and other key personnel of foreign affiliates, even if they are not directors and officers under the laws of the country where such affiliates are located.

D&O policies generally provide "claims made" coverage. Coverage is triggered and provided by the policy in effect when the claim is made, not when the allegedly wrongful conduct took place. Some D&O policies require not only that a claim be made, but also that it be reported to the insurer during the policy period. This type of provision generally should be avoided since it creates the possibility that no coverage will be afforded for a claim that was made but could not be reported during the policy period. At a minimum, a claims-made-and-reported policy should provide a specific time period after the policy period ends to report claims made during the policy period.

Because the trigger of coverage under a D&O policy generally is when a claim is made, the definition of "claim" is important. Insureds negotiating coverage should seek a broad definition of "claim" that encompasses written demands for relief, lawsuits, civil, criminal, administrative and regulatory proceedings and investigations. If employment-related claims are covered, EEOC hearings should be included in the definition. If entity coverage is purchased for securities or other claims, coverage should be triggered at the earliest stage of an administrative investigation and an insured may want the coverage to apply even if only the company is named in the proceeding.

In addition, the definition of a securities claim should not simply encompass offers to buy or sell securities of the company. It also should include any claims brought by a securities holder of the company, whether directly, by class action, or derivatively on behalf of the company. Claims against employees should be included in the definition.

A key issue for many public companies is whether the policy will cover investigations by the Securities and Exchange Commission. Many policies provide that administrative proceedings are covered that commence with a "filing of a notice of charges, formal investigative order or similar document against directors or officers" or against the corporation for a securities claim in the event entity coverage is purchased. This language triggers coverage once a formal investigation is begun. An insured may want to amend the definition of a securities claim to specifically include informal investigative orders or subpoenas.

Some carriers explicitly state that administrative proceedings against the company only are not covered, even for securities claims. In other words, a claim would have to be made against a director or officer along with the company for coverage to be triggered. That is an onerous restriction, especially where entity coverage is purchased, because SEC investigations are often started solely against the company with individual insureds added only if the evidence warrants. If significant resources in defense of an investigation are brought to bear early, charges against directors or officers may never be brought. Thus, it may be in the insurer’s interest to trigger entity coverage for administrative proceedings in addition to judicial proceedings.

If the definition of a claim is broad, insureds will have a corresponding obligation to broadly report such claims to the carrier. Procedures should be in place to recognize and report claims promptly.

The more time allowed to report a claim, the more favorable for insureds. Policies may provide for a specific time to report claims or there may be a requirement to report a claim to the insurer "as soon as practicable" after the claim is first made. Other policies provide, in addition to the "as soon as practicable" requirement, a 30- to 90-day post-policy period to report claims made within the policy period.

Recently, D&O policies provide that the time period for reporting claims does not begin to run until certain officials of the company, such as the risk manager or general counsel, have knowledge of a claim. These provisions reduce the risk that coverage might be jeopardized because a company official, with no knowledge of the reporting requirements of the D&O policy, became aware of a claim but failed to report it in a timely fashion.

In addition to actual claims, an insured also should be able to report potential claims to a carrier within the policy period.

Most D&O policies allow the insured to select counsel to defend the claim, with the carrier’s consent, but the payment of defense costs is charged against the limits of the policy. The defense costs are incurred by the insureds and typically indemnified by the corporation, which then seeks reimbursement from the carrier for the amounts paid.

Most policies require consent by the carrier to incur defense costs. Some require written consent, which could be difficult to obtain in an emergency situation such as a suit seeking injunctive relief. As a result, an insured may request a grace period to obtain consent after the defense costs are incurred.

For defense of securities and certain employment-related claims, at least one major D&O insurer requires its insureds to use law firms from a "panel counsel" list. Insureds may negotiate to include additional firms on the panel counsel list or seek to delete the provision altogether.

Given the high cost of defending claims, insureds should request mandatory advancement under all of the insuring agreements, whether coverage is provided directly to directors and officers, or for corporate reimbursement or entity claims. If advancement is tied to an agreement on allocation, insureds need to pay close attention to the allocation "test" under the policy.

Allocation refers to apportioning loss for covered and noncovered claims and covered and noncovered parties. Allocation disputes often arise where the corporation is named as a defendant in a suit where directors and officers also are sued, and "entity coverage" is not implicated. According to the 1998 Survey, for claims where at least some portion of defense costs or indemnity payments were allocated to D&O insurers, the average allocation to insurers of defense costs was approximately 62 percent and of indemnity payments was approximately 63 percent. Allocation thus remains a significant issue under D&O policies.

Most carriers now offer "entity" coverage for securities claims against the company. These policies should provide that coverage applies where a claim is made against the company even if no director or officer is named or if they are subsequently dismissed. Another option is "pre-determined" allocation for securities (and sometimes other) claims. Under this option, the corporation is covered only if the claim is also brought and maintained against directors and officers. Pre-determined allocation is usually cheaper than entity coverage because the coverage is narrower.

Other insurers simply state that the parties will use their "best efforts" to arrive at an allocation without specifying the process. Case law would provide the standard in the absence of specific policy provisions addressing allocation.

Selecting an option depends on cost, the case law that may apply and the allocation test for nonentity-covered claims. In other words, if entity coverage is selected for securities claims, the carrier’s treatment of allocation for nonsecurities claims should be reviewed.

Unfortunately, most carriers incorporate a "pro-insurer" test for the allocation of nonsecurities claims, providing that the insureds and insurer will use their "best efforts" to allocate, but that they will take into consideration the relative legal exposure of the insureds (such as the company and the individual defendants) and the relative legal benefits to each. The carrier will use a factors approach to decide which defendant had some exposure and which would receive a benefit by settling. Because insurers can always argue that the corporation would derive great benefit from settling by — for example — putting the litigation behind it, the test was viewed as pro-insurer.

This "relative exposure" test was incorporated directly into policy language after insurers lost court battles to have it be the test for allocation in the absence of specific policy language requiring it. See Caterpillar Inc. v. Great American Ins. Co., 62 F.3d 955, 961-62 (7th Cir. 1995); Nordstrom Inc. v. Chubb & Son Inc., 54 F.3d 1424, 1430 (9th Cir. 1995). Insureds should negotiate to delete the relative exposure language where possible.

If the policy is silent on the allocation question, or if the parties simply agree to use best efforts to allocate but do not specify the process, the allocation case law is favorable for insureds in many jurisdictions. Courts that reject the relative-exposure test have looked to whether the potential liability of the corporation is concurrent with that of its directors and officers and whether the potential corporate liability arose from the actions of defendant directors and officers.

The corporation is allocated a portion of any settlement (and, presumably judgment) only where its liability is not found to be concurrent with that of directors and officers and where it is determined that the independent potential direct liability of the corporation resulted in a larger settlement payment than otherwise would have been required. Piper Jaffray Cos. v. National Union Fire Ins. Co., 38 F. Supp. 2d 771, 80 (D. Minn. 1999). See also Nordstrom, 54 F.3d at 1433, Caterpillar, 62 F.3d at 963-64.

Absent policy language addressing the allocation of defense costs, case law provides that if these costs are reasonably related to a covered claim, the expense may be apportioned wholly to the covered claim. Continental Casualty Co. v. Board of Educ., 489 A.2d 536, 544 (Md. 1985); Federal Realty Inv. Trust v. Pacific Ins. Co., 760 F. Supp. 533, 538 n.3 (D. Md. 1991) (the insured is entitled to recover, in full, the costs of defending against covered claims regardless of the fact that the services incurred in defending against those claims also benefited either trustees on uncovered claims or uncovered parties).

Policy language should be analyzed carefully because many carriers treat the allocation of defense costs, judgments and settlements the same even though the case law may treat defense-costs allocation differently.

Certain exclusions may be of greater concern than others. If a private company contemplates going public, having an exclusion for claims relating to public offerings would potentially eviscerate the most important coverage sought. Some policies may also exclude claims based on an allegedly unfair or inadequate purchase price for the securities of the company or its subsidiaries. Other policies explicitly exclude claims for Section 16(b) insider-trading claims.

Even if a policy does not contain this exclusion, two other "standard" exclusions — for deliberately fraudulent or dishonest conduct and personal profit — may be raised. These exclusions should be negotiated so that the carrier may not rely on them to defeat coverage unless there is a final adjudication of dishonest conduct or personal profit. Requiring an adjudication may prevent the carrier from reopening the case to try to prove the conduct where the insured settles without an admission of liability. Most policies also exclude claims asserted by one insured against another insured (Insured v. Insured), with some explicit exceptions.

The exclusions that relate to personal conduct should also be severable — the wrongful conduct of one insured should not eliminate coverage for others.

Three "carve-outs" to the Insured v. Insured exclusion have become fairly standard and should be requested. They include coverage for: a) independent derivative claims; b) employment-related claims and c) cross-claims by an insured. A fourth, for claims by a bankruptcy trustee, may also be useful in the event of insolvency.

D&O policies cover "loss" but usually exclude from the definition taxes, fines, penalties, the multiple portion of any multiplied damage awards and punitive damages. Some carriers have agreed to cover punitive damages for securities claims so long as they are insurable under the law according to which the policy is construed. Other carriers have agreed to cover all punitive or multiplied damages, so long as it is not against public policy to insure them, and may agree further that the law of the jurisdiction most favorable to coverage will be applied to the disputes.

A "prior acts" exclusion may exclude coverage for claims that are based on wrongful acts of the insured that occurred before a certain date. The wording should be narrowed to the extent possible, if the endorsement can not be removed. Similarly, an exclusion limiting coverage for claims related to or based on any prior or pending litigation as of a certain date should be negotiated to narrow the scope of the exclusion and backdate it as far as possible. Ordinarily, if insurance coverage is being renewed (even if it is with a new carrier) and exclusions for prior wrongful acts or prior or pending litigation are included, they should be tied to the inception date of the corporation’s original D&O policy, not the inception date of the renewal policy.

Most carriers now offer, and insureds should request, an endorsement, at no cost, providing a $250,000 sub-limit of liability for investigation costs incurred in the investigation or evaluation of shareholder derivative demands. Insurers have asserted that such costs are not otherwise a covered loss.

Most D&O policies contain a limit of liability for all claims made during the policy period, which is typically one year. Insureds may want to lock in three-year policy terms if the price and policy conditions are favorable. Carriers may also offer to reinstate fresh limits each year or on a one-time basis. Such offers should be considered with attention to the adequacy of limits, the carrier’s ability to cancel the policy, and any predicted changes in the insurance market.

Most policies contain different retentions for corporate reimbursement claims and claims for direct payment to the directors and officers. Typically there is no retention for claims against directors and officers where the company is not indemnifying them. Most claims involve indemnification and are subject to the corporate reimbursement retention or the retention for entity coverage.

Recently carriers have offered to waive retentions for judgments and settlements of securities claims and may agree to waive the retention for defense costs where there is a finding of no liability of the insureds. Insureds should negotiate for the lowest retention and for a waiver of the retention in the greatest number of circumstances.

The policy provisions and issues discussed above are a sampling of the items that can be negotiated. One thing is certain: Negotiating terms at the inception of the policy is infinitely better than discovering policy pitfalls after a claim arises.