Insurers are pitching new D&O policies for independent directors.
Do they deliver what they promise?

The Recorder, Insurance Supplement, August 2003
By Mary E. McCutcheon

Blame it on the rise in corporate insolvencies, the duties imposed by Sarbanes-Oxley, or the fall-out from Enron and other financial accounting scandals — an independent director of a public company faces a greater risk of personal liability for corporate misconduct than ever before.  Corporate indemnifications, even if permitted for the claim at issue, may offer little protection where companies face financial difficulties in addition to legal problems.  Meanwhile, directors & officers liability insurance has become more difficult and expensive to purchase — and, insurers often seek to rescind or deny coverage for a significant claim.

In light of these concerns, in the past year insurers have introduced a variety of D&O products specifically focusing on protection for independent directors: so-called stand-alone or excess Side A coverage, personal or independent director liability policies, differences-in-conditions coverage, and audit committee coverage (referred to collectively here as “Side A policies”).  Side A policies can be purchased by one director for his/her sole protection, or by the company for the benefit of the entire board.  Prudent directors, as well as companies who wish to retain a qualified independent board, are examining these policies with interest. 

Ironically, these policies purport to provide coverage that independent directors often believed they already possessed under traditional D&O policies.  Thus, directors and companies are asking not only their risk managers and brokers, but outside counsel as well, to review these products and advise them on the adequacy of their entire D&O program.  Do these new products deliver what they promise?  If a claim is made, will an insurer find ways to disavow coverage just as it may under traditional D&O coverage? 

And perhaps most important, if policy wording can be negotiated, what language might provide greater protection for independent directors?

Side A Coverage

First, some background for D&O buyers.

Traditionally, D&O liability coverage consisted of “Side A” coverage, direct coverage to a director or officer if the company is not permitted or unable to indemnify the individual, and “Side B” coverage, which reimburses the company for payments made on behalf of a director or officer pursuant to an indemnification agreement.  As corporate concerns regarding the impact of securities claims on the bottom line increased, D&O insurers began to offer “B(2)” or “Side C” coverage, providing direct coverage to the corporate entity for securities claims.  The introduction of “Side C” coverage, while a benefit to the company, is now viewed as a disadvantage to independent directors.  The limits of liability available to directors for a significant securities lawsuit can be diluted by claims against the company.  Furthermore, if a company is insolvent, a bankruptcy court may order that any D&O proceeds be treated as an asset of the estate, and consequently unavailable to individual insureds for defense and indemnity costs.

Preservation of Limits for Independent Directors

Side A policies provide coverage to individuals only, so that the limits available for the directors cannot be eroded by corporate liabilities or frozen by a bankruptcy court.  Unless the Side A policy is purchased by an individual director for his or her sole protection, however, the number of insureds entitled to protection under the policy may render the policy less attractive to an independent director.  Many of these policies also cover inside directors and other officers, often defining “officer” to extend to “manager.”  Accordingly, one of the advantages of Side A coverage — preserving limits for independent directors —can be defeated by the number of insureds with rights to that coverage.

Excess/Primary Protection

Some Side A policies provide coverage that is strictly excess to the underlying policy, and does not “drop down” to provide primary coverage if the underlying insurer rescinds or otherwise denies coverage, or if the underlying insurer is insolvent.  The insured, therefore, may bear a large portion of the loss as uninsured.  Other policies will provide primary protection in some or all of those circumstances.  Certain policies include “differences in conditions” features that not only provide excess coverage, but also provide primary coverage for claims typically not covered under a primary D&O policy, e.g., ERISA, errors and omissions, libel and slander and (limited) pollution claims.  Underwriting considerations and pricing may determine the availability of these alternatives.

Because Side A policies generally are written as excess to traditional D&O policies, an insured can be at the mercy of a dispute between the primary and Side A insurers.  The primary D&O insurer may deny coverage, but the Side A insurer may refuse to step in because it believes the primary insurer is wrong.  Language specifying that the Side A insurer will provide coverage even if the primary D&O insurer “wrongfully” denies coverage eliminates this dilemma.

Non-Rescindability

Is any policy truly “non-rescindable?”  What the large print giveth, the small print taketh away.  Even if a Side A policy is marketed as “non-rescindable,” it may exclude coverage for a claim if the underlying policy is rescinded “as a result of any … act, error or omission by the insured person.”  Thus, although the Side A policy technically remains in place, a director involved in the circumstances that lead the underlying insurer to rescind coverage (e.g., providing inaccurate revenue information submitted in connection with the underlying policy application), may find that coverage is excluded for a claim arising out of that conduct, regardless of the director’s level of culpability. 

Furthermore, Side A policies can be subject to warranties, by which an officer of the company is required to warrant in the application that none of the insureds (directors or officers) has knowledge of any facts that could give rise to a potential claim.  Again, although the policy is not rescinded and technically available for other claims, if a claim arises out of facts that were known to any insured, coverage for that claim would be excluded as to all insureds.  (Murphy’s Law dictates, of course, that coverage will be needed only for that excluded claim.)  Thus, the policy and application should be examined to insure that exclusions or warranties do not undercut the policy’s purported “non-rescindability.”

Defining Your Terms

In addition to features unique to Side A   coverage, policy forms vary in the wording of definitions and exclusions also found in traditional D&O policies.  The following are some provisions of particular concern to independent directors:

• Does the definition of “claim” extend to regulatory and criminal investigations (e.g., SEC investigations) and if so, at what point in the investigative process does coverage commence?
• Does the definition of “loss” include coverage for fines, penalties and punitive damages under a favorable choice-of-law provision?
• Does the policy contain exclusions for liabilities created by Sarbanes-Oxley (e.g., precluding coverage for payments prohibited under the act)?  
• Does the fraud exclusion apply only when there is a final adjudication of fraud, or can the exclusion be triggered merely by evidence of fraud?  (While traditionally it was assumed that the “final adjudication” language was preferable in all instances, a negligent independent director sharing policy proceeds with a guilty insider would prefer language that allows the insurer to deny coverage to guilty insureds without a final adjudication of fraud, preserving policy limits for innocent insureds.)

Other Provisions

Audit committee coverage may advance defense fees for a claim triggered by a restatement of a financial statement, but the insured should be aware that the policy may require return of those fees if it is proved that the initial financial statement contained materially fraudulent information, regardless of whether the insured had knowledge of the fraud.

“Insured v. insured” exclusions vary significantly.  Without appropriate wording and exceptions, they can exclude coverage for derivative actions, claims by a company in bankruptcy or situations where one of the directors has settled with a plaintiff and is providing cooperative testimony in the ongoing action.

Does the policy allow the individual to purchase an extended reporting period (“ERP”) in which to report claims based on acts committed during an expired policy?  An ERP preserves continuity of coverage for a company moving to a new insurer (who may exclude coverage for claims based on acts committed before its policy incepted), or for a company going out of business.  An insolvent company may opt not to purchase the ERP; ideally the individuals should be entitled to purchase this protection as well.  Also, the premium for the ERP should be fixed at a percentage of the policy premium, rather than left to the “discretion” of the insurer.

Side A policies may include oppressive choice-of-law and alternative dispute resolution provisions.  They can force the insured into an inconvenient ADR forum (e.g., London), or impose an unfavorable choice-of-law clause (e.g., New York law).  These provisions may also allow the company, rather than the director, to control the ADR process — not a desirable situation if a former director and new management are at odds. 

Careful review of a proposed Side A policy may not result in coverage for all exposures faced by an independent director, but it will at least apprise the company and director of the scope of the coverage that they have purchased, can minimize surprises in the event a claim arises, and may result in an improved policy.