D&O 101

Until recently, many, if not most directors of public companies were content to know their company had a directors & officers (D&O) insurance policy and assumed it gave them adequate protection. They took primary comfort from corporate bylaws that generally required advancement of their legal expenses and provided for broad indemnification in the event of a claim against them. No doubt, they were aware that outside directors were rarely held liable for damages in suits brought against them and that most cases settled without their having to go out-of-pocket. Then Enron happened, and WorldCom, and Hollinger, to name just a few of the many recent corporate scandals. The upshot of those corporate scandals and the consequent heightened media, regulatory, and investor scrutiny is that it is now more crucial than ever for directors to take an active interest in their company’s D&O policy.

D&O basics

Over the years, D&O insurance evolved into what is known as A-B-C coverage. “Side A” coverage provides for indemnification of individual directors and officers where the underlying claim against them is nonindemnifiable—i.e., where the company legally is not permitted to indemnify them. “Side B” coverage reimburses the company (often subject to a substantial deductible) for proper indemnification payments made to its directors and officers. “Side C,” or entity coverage, covers the company (also typically subject to a large deductible) for claims against it, such as securities law claims. Sounds great, right? Just get lots of A-B-C coverage and you’re all set, right? Well, actually, no.

Potential problems

Here are just a few of the things that could go wrong, as recent cases demonstrate.

Fraud in the application—Before an insurer issues a policy, the potential insureds must submit an application. Directors should, but rarely do, see this application. That document, which typically incorporates the company’s financial statements, becomes part of the policy. In addition, the CEO or CFO usually represents that there are no facts and circumstances of which he or she is aware that might give rise to a future claim covered under the proposed policy.

So what happens if the financial statements are materially misstated or the representation in the application is false? In a worst-case scenario, the insurer could seek to rescind the entire policy, leaving all directors and officers without any coverage, whether they knew of the fraud or not and whether or not they themselves made the false representation. Rescission is a draconian result yet, it is a remedy that D&O insurers have sought or obtained in a number of recent high-profile cases, such as Tyco, Healthsouth, and Worldcom.

Shared limits—Under traditional D&O coverage, all insureds—outside directors, officers, and the company itself—share the policy’s limits. One risk to a director under this structure is that coverage for directors could be adversely affected where per-claim or aggregate policy limits are reduced by the corporation’s liability and costs. Remember “losses” covered by the policy generally include settlements, judgments, and defense costs; therefore, the company’s legal expenses can deplete available insurance coverage.

A similar risk exists where a bad actor—for example, a CFO knowingly involved in financial misstatements (think Andrew Fastow in Enron)—uses a disproportionate share of the coverage on defense costs. Another risk of shared limits, perhaps more remote, but not simply theoretical as demonstrated by the recent experience of Hollinger International directors, is that the insured company could oppose use of the policy to fund a settlement of claims against directors the company has come to view as out of favor.

Bankruptcy—A company’s bankruptcy accentuates the problem of shared limits. Where the D&O policy includes “Side C” entity coverage for securities claims, courts routinely freeze D&O policies on the ground that they are property of the bankruptcy estate, thereby temporarily, if not permanently, leaving directors and officers without access to the policy’s proceeds.

Another risk bankruptcy poses derives from an exclusion in D&O policies known as the insured vs. insured exclusion. This exclusion provides that a claim brought by one insured against another will not be covered. Among other examples, a bankruptcy trustee “standing in the shoes” of the corporation could be considered an insured under the policy, with the result that directors and officers would not be covered for claims brought by the trustee against them.

DOJ/regulatory investigations—Heightened media and regulatory scrutiny means that the risks to directors of being dragged into criminal/regulatory investigations can no longer be overlooked. Indeed, the cost of dealing with criminal/regulatory investigations, which often require extensive document production and lead to insured individuals and the company retaining separate counsel, can be significant. Unfortunately, many D&O policies exclude coverage for investigatory expenses incurred prior to the bringing of formal charges against the insured individual. To make matters worse, due to increased pressure from regulators who have taken a hard line against companies indemnifying potential wrongdoers, the company may actually refuse to indemnify the director being investigated.

Bad conduct exclusions—D&O policies generally exclude from coverage matters that are uninsurable under state law (e.g., for public policy reasons), criminal or fraudulent acts, acts involving illegal profit or personal advantage, ERISA violations, and possibly fines and penalties imposed by governmental body (e.g., penalty for a knowing and willful certification not in compliance with applicable securities laws). Absent a properly drafted policy provision, a director may experience a denial of coverage based on the allegations in the complaint, a carrier’s subjective view of the director’s “misconduct,” or based on another insured’s fraudulent acts.

What to do?

All these caveats make the ability to find adequate D&O protection sounds pretty tough, right? Perhaps. However, while no policy can provide absolute protection against all possible claims, the good news is there are proactive steps a prudent director can take to seek to minimize the risks.

Severability in the application—To protect against the risk of rescission, directors should ask to have the application “severable.” A severability clause protects an innocent director by precluding the carrier from relying on the misrepresentation of one insured to deny coverage to all. There are variations in the scope of severability clauses, however. For example, “full severability” means that knowledge (of a fraud or misrepresentation) by one insured will not be imputed to other insureds. But a more limited severability clause may impute the knowledge of a company’s CEO and CFO, or other corporate officials, to other insureds.

Dedicated Side A coverage—The market has attempted to address the risks posed by rescission and shared limits through separate Side A-only policies. For example, directors and officers can buy their own insurance policies that are separate and apart from the company’s coverage through a standalone Side A policy.

Another approach is to purchase a form of excess coverage recently introduced to the market known as Side A difference-in-conditions (or DIC). Side A DIC offers more favorable terms (such as fewer and narrower coverage exclusions) than a traditional D&O policy. Most significantly, this coverage kicks in when the primary D&O coverage is unavailable, for example, because of the corporate entity’s bankruptcy or where the underlying D&O policy has been rescinded due to material misrepresentations in the insurance application. Finally, there are standalone policies available that exclusively cover a company’s outside directors. These Independent Director Liability policies, which like Side A DIC are new to the market and attach excess of the underlying coverage, often contain the same coverage enhancements as Side A DIC policies, with the added advantage of eliminating the concern that coverage for the outside directors will be diluted as a result of claims against inside directors and/or officers of the company.

Narrow the insured vs. insured exclusion and broaden the definition of claim—Carriers often will negotiate the scope of the insured vs. insured exclusion. A good first place to start in narrowing the scope of this exclusion is to carve out from it suits brought by an independent bankruptcy trustee. Similarly, try to carve out suits brought by former directors or officers, as these suits otherwise would be excluded.

On the other side, seek to broaden coverage through negotiation of the definition of “claim” under the policy. “Claim” typically will be defined to limit coverage to formal investigations, with coverage triggered only by the bringing of a suit or filing of formal charges. To address this, seek to have “claim” include informal investigations, with the trigger for coverage being receipt of a subpoena (or, somewhat less favorably, the identification in writing of the insured as a person against whom charges may be filed).

Severability in exclusions and final adjudication requirement—The bad conduct exclusions described above can be addressed in certain ways. First, to avoid being tagged with a bad actor’s wrongdoing, the policy should provide that the conduct of an individual insured will not be imputed to any other insured. This is known as a non-imputation clause or as “severability of exclusions.”

Second, the standard for judging misconduct should be made clear. Mere misconduct “in fact,” a “written admission” of misconduct, or the plaintiffs’ allegations in the underlying suit, should not be enough to trigger the exclusion. But it might be unless the policy contains “final adjudication” language providing that before coverage can be denied under the exclusion, there must be a final adjudication (preferably in the underlying action itself) adverse to the director that such bad conduct indeed occurred.


The foregoing are some specific policy and wording solutions to the particular problems identified above. There are many others. Of course, as with many things, the devil is in the details. For that reason, to ensure sound D&O coverage, directors should get personally involved in the company’s D&O renewal process, require the company’s broker to make direct presentations to the board early in the renewal process, and have counsel thoroughly review coverage terms and conditions, again, early in the process.

Remember, it is the director’s wallet on the line if the company’s D&O policy is deficient. Given that and the increased liability risks confronting directors today, D&O insurance should not be seen as another item in the company’s budget, but as a key element of the company’s business that is worthy of directors’ personal attention.

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