Directors and Officers Liability: Exposures, Risk Management and Coverage, 2nd Edition

Joseph P. Monteleone

• Publisher: The National Underwriter Company
• Year: 2013
• Print ISBN: 9781938130878
• eBook ISBN: 9781938130885
• Edition: 2
• Topic: Business
• Subtopic: Insurance
• Index: Business

With liability often looming just over the horizon, corporate directors and officers rely on liability insurance and indemnification for peace of mind. Finally, there is a book that spells out in detail how these protections really work—and how they differ.

Directors and Officers Liability: Prevention, Insurance and Indemnification examines such topics as: the risks officers and directors face; derivative and class actions; when insurance is available; and when a corporation is required—or allowed—to provide indemnification. The authors have included comprehensive coverage of indemnification agreements and liability insurance policies, with point-by-point analysis of provisions, procedures, exceptions and gray areas.

Book #00659; looseleaf, one volume, 678 pages; published in 2000, updated as needed; no additional charge for updates during your subscription. Looseleaf print subscribers receive supplements. The online edition is updated automatically. ISBN: 978-1-58852-095-1.

Chapter 1: Introduction

Directors’ and Officers’ (D&O) liability insurance policies have evolved to a great extent today from their origins about eighty years ago. Yet, in many ways the fundamental nature and purpose of the coverage remains the same, i.e. an insurance policy intended primarily for the protection and benefit of the duly elected directors and duly appointed officers of the corporation. Any insurance provided to the corporation itself and nonofficer employees, as is common in many current policy forms, remains secondary to the goal of protecting the officers and directors.

The Origins and Evolution of D&O Liabilities and Insurance

The first D&O liability insurance policy forms were introduced in the London insurance market after the United States Congress enacted the Securities Act of 1933, which was passed following the stock market crash of 1929. The Securities Act was a response to allegations of corporate fraud in the early 1930s. Although the 1933 Act was considered landmark legislation at the time, it was limited in scope and was quickly followed by the Securities Exchange Act of 1934. This Act expanded the federal government’s authority to regulate securities by establishing the Securities Exchange Commission (SEC) and ultimately promulgating Rule 10b-5; a foundation for present day securities fraud litigation. While this legislation continues to apply to the most significant claims faced by public companies in the United States today—securities fraud class actions—the federal securities laws continued to evolve with the passage of the Private Securities Litigation Reform Act in 1995 (PSLRA) and the Securities Litigation Uniform Standards Act in 1998 (SLUSA). More recently, in 2002, Congress passed the Public Company Accounting and Investor Protection Act of 2002 (SOX) and later the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) in an effort to restore consumer confidence in the stock markets following corporate scandals involving high profile companies such as Enron and WorldCom, as well as the credit crisis and ensuing financial collapses in 2008. Dodd-Frank is still undergoing considerable rulemaking activity almost two years after its passage, and much remains to be seen as to its ultimate impact.

The statutory and common law sources of liability, along with D&O insurance, have evolved over the years in both nature and scope as more insurers have entered the marketplace and policies have begun to be tailored for different types of risks. While D&O insurance for public companies continues to receive the most attention in the business and legal media, there are three primary D&O markets, each with its own unique attributes:

• • Public company D&O
• • Privately-held company D&O
• • Not-for-profit organization D&O

Although the lines are not as distinctly drawn in the private and not-for-profit sectors, historically there have been three fundamental coverage grants or insuring agreements in a D&O policy. In the last few years, while some insurers have expanded the number and scope of the coverage grants in their policies to meet the changing needs of their insureds, the basic insuring agreements—and the purpose for them—have remained the same.

D&O policies contain what is commonly called “Side A” coverage. Many would consider this D&O insurance in its purest form: a product designed solely to cover the nonindemnified exposures of an organization’s directors and officers.

Laws governing indemnification by a public or private corporation, as well as by not-for-profit organizations, vary from state to state. The law of the state where the company or organization is incorporated or organized must be followed. The state where the organization is incorporated or organized may or may not be the same as the state where the company is headquartered or has its principal place of business. For example, many public companies, regardless of where they are headquartered, continue to be incorporated in Delaware because of the favorable business laws in that jurisdiction.

Indemnification laws, particularly over the past few decades, have become so broad in scope that almost all but the most egregious misconduct may be indemnified. The nuances of indemnification law will be discussed in greater detail in Chapter 3, but it is important to note that most “wrongful” conduct of directors and officers will be indemnifiable, and in fact indemnified, by the corporation. Thus, only a minority of claims will be subject to Side A coverage; usually only a situation where the organization is bankrupt or otherwise financially unable to provide indemnification, or prohibited by laws from providing indemnification. Such is the case in a shareholder derivative suit settlement or judgment where indemnification is prohibited by Delaware and the majority of other states. Unlike insurance, corporate indemnification is generally not subject to any monetary limits of liability unless designated in the corporation’s articles of incorporation, charter bylaws. However, as in the case of an insolvent insurer, a corporation’s obligation to indemnify its directors and officers may be worthless in the event of the corporation’s financial collapse.

Although in the last few years there has been a proliferation of D&O policies that solely provide Side A coverage, most D&O policies contain a “Side B” coverage generally applicable whenever there is a covered claim for which the corporation or organization lawfully indemnifies, or is required or permitted to indemnify, the director or officer for that claim. Although the corporation is not itself insured under the policy for its own liability (except in Side C situations, described below), payments under Side B are made by the insurer to reimburse the corporation for its indemnification payments to the individual insureds. Someone unfamiliar with D&O insurance should not be confused by the organization’s insured status because the Declarations to the policy may well designate the organization as the “named insured” or “insured organization.” The organization, however, is insured only to the extent it indemnifies its directors and officers. The vast majority of claims under a D&O policy are under Side B precisely because of the breadth of indemnification under the law.

Until the mid-1990s, there was no Side C, or entity coverage, provided to the corporation, especially to public companies. The concept emerged because of costly and protracted disputes over allocating coverage between the uncovered corporation, on one hand, and the insured individual defendants, on the other. In many cases, all defendants were represented by the same counsel and settlement agreements and judgments did not provide for any particular allocation of liability. Therefore, the disputes centered on allocating not only those settlement or judgment amounts, but also the defense costs incurred. As those disputes were most highlighted in the securities arena because of the magnitude of the settlements, entity coverage was introduced under D&O policies issued to public companies for “securities claims” as defined in the policies. Thus, with individuals and the corporation, as well as nonofficer employees—both covered under the policy—allocation disputes arising from the corporation’s status as an insured under the D&O policy came to an end for all practical purposes. Nonetheless, under the majority of D&O policies on the market today, the large public company typically remains uninsured for all other claims outside the realm of securities matters.

Reasons for Buying D&O Insurance

There are two primary purposes for obtaining D&O insurance.

The first is to protect individual directors and officers. Historically, D&O products were referred to as “sleep” insurance for the directors and officers. In a sense, D&O insurance complements corporate indemnification by providing this protection. In the majority of claim situations, the individuals need not be directly concerned with D&O insurance because their liability exposure and legal expenses will be subject to indemnification. Nevertheless, D&O insurance may become the individual’s primary source of protection in situations where the corporation becomes financially insolvent. Also, as stated above, particularly in Delaware and the many other states that follow Delaware law in this area, corporations cannot indemnify an individual for a settlement or judgment amount when he or she is sued by a shareholder or other party on behalf of the corporation. These are commonly known as derivative actions, and the primary rationale for holding a settlement or judgment amount obtained in one to be nonindemnifiable is that it would, in effect, make for a circular recovery. Specifically, as the purpose is to recover money for the corporation, it would defeat that purpose to require the corporation to reimburse an individual director or officer for whatever he or she may owe. There is, however, no prohibition against an insurer stepping in to pay these amounts on their behalf. Thus, D&O insurance acts as a backstop here where indemnification is prohibited.

One cautionary note, however, is that in the case of an insolvent corporation, the directors and officers are left with only recourse to the D&O insurance, which has a finite limit. Although rare, there are in fact cases where the D&O limits are simply not sufficient enough to protect the individuals and contributions need to be made from their personal assets. Arguably, this took place in the context of the Enron settlement a few years ago.

The second purpose of D&O insurance is quite simply balance sheet protection. The policy is not always readily thought to be such a vehicle but, given the scope of corporate indemnification, more often than not it is the company that is being reimbursed under the policy for its indemnification and defense expense advancement.

How D&O Insurance Differs from Other Insurance Products

Aside from the intrinsic nature of the coverage, D&O insurance coverage differs from other insurance products in significant and, depending upon the nature of the product being compared, various ways. Corporations in the United States, whether for-profit or not-for-profit, almost universally purchase general liability coverage. Such policies commonly cover bodily injury, property damage and personal and advertising injuries. D&O policies typically do not afford coverage for such claims and, in fact, may specifically exclude coverage for bodily injury, property damage, and personal injury. In addition, while general liability insurers typically have the duty to defend their insureds in the event of a claim, the insureds have the duty to defend themselves under D&O policies issued to publicly traded corporations. As a result, D&O policies issued to public companies often have, with certain exceptions, large self-insured retentions that must be satisfied before the insureds can receive payment for defense costs or other loss. In contrast, general liability policies often have measurably smaller deductibles that do not apply to defense costs.

In addition, D&O policies issued to public companies often specifically exclude coverage for employment-related claims, as they are tailored to address the major exposure faced by the organization which arises from their status as a publicly traded organization. A specific exclusion is necessary because the definition of “wrongful acts” in such policies is often so broadly worded that the policy’s coverage may encompass acts or omissions involving employees of the company. Many public companies purchase coverage for employment-related practices from insurers offering standalone policies. However, some insurers offer coverage for employment-related practices by endorsement to the basic D&O policy form. D&O policies issued to private companies frequently cover employment claims, via an expanded definition of the term “wrongful act”, since that is often the primary exposure faced by such companies. Similar to standalone employment practices liability insurance policies, the insurer commonly has the duty of defense under D&O policies affording coverage for employment practices.

D&O policies also typically exclude coverage for claims arising from liability under the Employee Retirement Income Security Act of 1974 (ERISA), even though a corporation’s directors or officers may have some exposure under ERISA as a result of their administration of the corporation’s employee benefit plans. As interest in coverage for such types of claims has increased, many insurers offer standalone fiduciary liability insurance policies and a few provide such coverage by endorsement to their D&O policies.

Another type of coverage currently generating interest in the insurance industry arises from cyber liability exposure. Cyber risks generally fall into one of three categories: intellectual property (trademark, patent, and copyright infringements), privacy, and network security. Some claims arising from these types of risks may be covered under D&O policies to the extent they involve an alleged “wrongful act” of a director or officer and are not otherwise specifically excluded. While the standard exclusions for property damage and personal injury will preclude coverage for cyber risks in many cases, advances in technology may result in exposure currently not contemplated by insurers. Consequently, as cyber risks continue to grow in complexity and increasingly impact the corporate world, insurance for such risks will need to be synchronized with an insured’s other business liability coverages, including its D&O insurance.

 

Chapter 2: Claims

Introduction

Whether corporations are formed with a for-profit or not-for-profit purpose, or whether they are publicly or privately held, claims against them arise from a wide variety of sources and potential exposures. As discussed in detail in Chapter 4, private companies, not-for-profit entities, and public corporations all have issues specific to their nature impacting their potential exposure for claims. However, those specific issues aside, one of the primary exposure sources of claims faced by all three types of organizations flows from the fundamental corporate duties owed by directors and officers to their organizations, shareholders (based on nature of organization), members,—and in some cases—other directors and third parties. Those duties, which are rooted in the common law but have been codified in many states, consist of the duties of care, loyalty, and obedience.

In addition to claims arising from breaches of fiduciary duty owed by directors and officers, another significant exposure for organizations involves claims arising from employment practices. While employment claims are typically brought by employees against their employers, they may be brought by third parties who deal with the corporation, such as customers and vendors. Claims by third parties, including competitors, creditors, customers, regulators—and in the case of not-for-profit organizations, donors and beneficiaries—have increased in recent years. This chapter discusses the primary sources of claims against corporations and their directors and officers, and the process of handling D&O claims by an insurance company and/or its agents.

Until the late 1980s, it was scarcely an exaggeration to say that all of the reported judicial decisions interpreting directors and officers (D&O) liability policies could be counted on one’s fingers. In the ensuing years, there have been a plethora of officially reported and unreported decisions, many of which are available on electronic legal research databases such as Lexis® and Westlaw® or through informal networking of outside counsel and claims professionals. While not all of these decisions have been a source of clear guidance from the courts and there are restrictions as to whether and how an unpublished or “not officially reported” decision can be used as case precedent, these decisions help educate the D&O community as to the clarity and interpretation of policy provisions and what may be considered appropriate claims handling practices. The most important and frequent areas of insurance coverage disputes will be discussed thoroughly in Chapter 8.

Despite a body of insurance coverage law, many practical claims handling problems arise and old ones persist. For example, there are frequent disputes over interrelated wrongful acts and interrelated claims provisions because resolution of these issues is fact sensitive. Further, there are a large number of coverage disputes resolved through arbitrations which are, for the most part, confidential. This confidentiality precludes the community from having the opportunity to learn from reading the results and reasoned opinions rendered by the arbitrator or panel of arbitrators.

The Claims Handling Process1

A number of important parties are involved in the D&O claim handling process. These fall into three basic categories.

(1) The insurance company.

(2) The policyholder.

(3) The broker.

The Insurance Company

D&O liability insurers generally employ lawyers or other sophisticated claims professionals to handle claims under their policies. Because many D&O policies do not impose a duty to defend on the insurer2 (rather, they impose an obligation to pay defense costs), a D&O claims handler’s role is as much to protect the interests of the insurer as it is to deal in good faith with the insureds under the policy regarding coverage and an ultimate resolution of the litigation.

Particularly in cases involving complex securities law violations, the D&O insurer claims lawyers may sometimes also retain outside counsel to assist them in handling these claim matters. Such counsel is typically referenced as coverage or “monitoring” counsel. While in most situations the counsel performs both coverage and monitoring roles, there is a subtle distinction between the two functions. The coverage function encompasses giving the insurer legal advice on coverage based upon applicable law, and communicating the insurer’s coverage position to the insureds or policyholder. If necessary, due to the dispute degenerating into a litigation or arbitration proceeding, that counsel will likely also represent the insurer in such proceedings. The monitoring function, on the other hand, is sometimes limited to interfacing with the policyholder’s chosen defense counsel and reviewing billings and strategic decisions in handling the defense. Billing and settlement strategy issues often implicate coverage issues as well, and thus the two functions may merge. It is important to note that coverage or monitoring counsel owes no duty to the insureds. This counsel’s sole obligation is to protect the interests of its client—the insurer.

Well-qualified monitoring and coverage counsel nonetheless may be able to offer some helpful insights and assistance to defense counsel in effecting a favorable resolution of the litigation for both the insurer and its insured defendants. Despite the often unavoidably adversarial positions that develop, it is important to remember that both the insurer and its insureds are aligned on the defense side in the litigation, and there is much mutuality of interest.

Although the insurer’s inside claims professional and, in some cases, outside coverage counsel are usually the primary, if not sole, insurer representatives in handling a claim, other key individuals may also play a constructive role.

First, at the time the policy was initially purchased, the situation usually was the converse of the claims situation, i.e., the primary contact with the insurance company was through its underwriting personnel. These individuals generally have the greatest appreciation of the overall and long-term business relationship between the insurer and the insured company. Especially when that business relationship has been both good and long-standing, underwriters may be able to help facilitate a resolution of disputes over coverage and/or claims handling.

However, the fact that insureds deal with diff...

Table of contents

• Preface
• Chapter 1: Introduction
• Chapter 2: Claims
• Chapter 3: Indemnification
• Chapter 4: Key Exposures for Public, Private and Not-for-Profit Entities
• Chapter 5: The D&O Insurance Procurement Process
• Chapter 6: D&O Insuring Agreements and Coverage Triggers
• Chapter 7: The Key Policy Provisions
• Chapter 8: Areas of Frequent Coverage Disputes
• Chapter 9: Related Management Liability Insurance Products
• Chapter 10: International D&O Risks and Other Emerging Risks
• Appendix A: Litigation Management Program
• Appendix B: Hudson Public Company D&O Policy with Declarations
• Appendix C: Hudson Not-For-Profit Form, Declarations, General Terms & Conditions, and D&O Policy
• Appendix D: Hudson Side A Only DIC D&O Policy with Declarations
• Appendix E: Hudson Excess Policy with Declarations
• Appendix F: Legal Status of Punitive Damages Insurability