Background.  To address the risk of personal liability that directors and officers may face for claims made against them in their corporate roles, companies often purchase director and officer (“D&O”) liability insurance.  The role of such insurance is often characterized as filling in the potential gaps of risk where other corporate protections (such as indemnification) may fail or be subject to circumstances beyond the control of the insured.  Yet D&O insurance policies can have their own gaps in coverage due to different approaches to covering liability, and companies may not realize that a “one-size-fits-all” policy lack important aspects of coverage that they either assume that they have or don’t know that they need.  This article will highlight some of ways in which D&O insurance policies may be structured to better address those vulnerabilities.

The Elements of D&O Insurance.  D&O insurance policies are purchased by companies to provide coverage for certain types of claims made against (or involving) officers and directors of a company.  Insurance is both a risk management tool and a separate source of funds to the mutual benefit of the company and insured directors and officers alike.  The basic elements of a D&O policy include:

• Specifically Included (and Excluded) Claims. A D&O insurance policy has defined coverage for certain claims, and excludes coverage for other types of claims.  Covered claims may cover a wide range, but breach of fiduciary duties, conflicts of interest, disclosure issues (for public companies) and the like.  D&O insurance policies generally exclude coverage for intentionally dishonest conduct, fraud, willful violations of law and criminal behavior.  Claims can come from shareholders, creditors, regulators (e.g., investigations), consumers and others. 

• Limits of Coverage. As with insurance policies generally, D&O policies have dollar-amount limits as to the various claims insured.  This may involve an aggregate limit for all claims under the policy (i.e., the maximum amount the insurer has to pay under the policy) and sub-limits for particular types of claims.  

• Timing of the Claim. Most D&O insurance policies operate on a “claims made” basis, meaning that they only provide coverage if the claim against the insured is made during the term of the policy.  Some D&O policies further require that the claim must be both made and reported to the carrier during the policy term (a “double anchor policy”), while some allow a grace period for notice after the policy expires.

• The “Tower”. The traditional D&O insurance “tower” is divided into A, B, and C “sides” having different types of coverage:

• Side A.  The “Side A” of a policy directly covers directors and officers personally for where they are not indemnified because of limits of law or practice (such as discussed below) or the stressed financial capability of the company.  

• Side B.  The “Side B” of a policy covers the company for its payment obligations for director and officer indemnity, usually subject to a “retention” or deductible amount that the company is responsible for paying first.  Its purpose is to assist the company in risk management and provide assurance of funds to meet indemnity obligations.

• Side C. The “Side C” of a policy provides coverage for the company itself as an entity.  In the case of public companies, Side C is usually limited to securities claims.

• Retention. It is common for D&O insurance policies to require that the company pay a “retention” or deductible amount first, before the insurance company has to pay on the policy.  Sometimes this is referred to a SIR (self-insured retention).  This retention requirement sometimes applies to Side A direct coverage, but typically applies to Side B reimbursement coverage and Side C entity coverage.

How Exculpation, Indemnification, and Advancement of Expenses Apply.  In assessing the adequacy of a D&O insurance policy, companies should first understand how they already protect their directors and officers from personal liability.  Under state laws, a company may provide (in its articles of incorporation and bylaws) certain limitations for director and officer liability—called exculpation and indemnification---and may also promise to advance legal expenses incurred by a director or officer in such cases.  Companies may enter into indemnification contracts with directors and officers as well.   While these provisions may vary from state to state, “exculpation” absolves a director (but not an officer) for monetary damages owed to the company for simply negligent breaches of the duty of care, whereas “indemnification” is an undertaking by the company to pay (or reimburse) the legal costs incurred to defend the director and officer against, and to pay, certain claims. 

Exculpation and indemnification do not apply, however, if (and to the extent) the director or officer fails to meet a described “minimum standard of conduct,” as the company should not have to waive a claim or pay for situations where their director or officer has acted in bad faith or in a criminal manner, or has benefitted personally at the expense of the company.  Similarly, to receive advancement of expenses the director or officer must undertake to repay to the company any amounts advanced if he or she is determined to be not entitled to indemnification, e.g. when it has been judicially found that they have acted outside of the minimum standard of conduct.  For a more detailed discussion, see When Directors and Officers Are Sued: How Exculpation, Indemnification and Advancement of Expenses Works (And Doesn’t Work).

Gaps in Indemnification and Advancement of Expenses.  Exculpation, indemnification and advancement of expenses do not always come to the rescue of directors and officers defending claims.  While the classic problem of exculpation---courts do not uniformly allow it to dismiss a claim before discovery—cannot really be addressed by insurance, a carefully postured D&O insurance policy can address many of the potential shortcomings of indemnification and advancement of expenses.  Inasmuch as D&O insurance involves a payment toward costs or a claim by the insurance carrier, not the company who bought the insurance, D&O insurance can respond where the company itself has trouble paying indemnification, such as: 

• procedural and substantive problems in getting indemnity claims paid out of company assets in bankruptcy
• legal prohibitions on indemnity for shareholder lawsuits on behalf of the company (derivative claims)
• obtaining reimbursement of legal fees incurred if the director or officer must sue the company to compel it to advance expenses or obtain indemnity (‘fees-on-fees”) and
• federal government rules or policies against indemnification (e.g., the Securities and Exchange Commission’s policy against indemnification for violations of securities laws).

Helpful D&O Insurance Solutions.  In considering a D&O insurance policy, companies often seek to have the insurance carrier undertake both a duty to indemnify (to pay claims) and a duty to defend (to pay defense costs of claims).  To the extent practicable, the policy should address the gaps in indemnification and advancement of expenses outlined above.  There is a cost-benefit analysis to assessing adequacy of coverage, coverage limits, retention amounts and the like.  A good insurance broker can help in this exercise and provide perspective on market norms and several choices of competitively priced policies.  In addition to that, a company (and its directors and officers) should consider to what extent the D&O insurance policy “fills in the gaps” of potential liability protections.  Some helpful products and provisions to consider include:

• Stand-Alone Side A DIC Insurance. The insurance industry responded to many of the gaps in coverage faced by directors and officers when it created Side A “Difference in Conditions” (DIC) insurance. This insurance typically provides direct coverage to directors and officers that is not shared with the company inside the typical A-B-C insurance tower, does not have a retention amount, and is not subject to cancellation by the carrier (except for nonpayment of premiums).  Side A DIC can add to the coverage under the A-B-C tower and “drop down” where other coverage is exhausted or denied.  For example, Side A DIC may provide coverage where the A-B-C primary coverage is restricted or denied in:

• bankruptcy situations (the Side A DIC isn’t shared with the company and is generally not seen as property of the debtor’s estate)
• exhaustion of the limits in the A-B-C insurance tower (the Side A DIC is outside of the tower)
• retention payment failures (Side A DIC usually does not have a retention)
• areas where the general Side A policy denies coverage, for example pollution exclusions and punitive damages/fines/penalties exclusions, and the “insured versus insured” exclusion
• cases involving the rescission of the primary A-B-C policy.

Because of its generous “dollar one” coverage, Side A DIC coverage can be fairly expensive compared to regular Side A coverage.

• Side A “Excess” Coverage.  In lieu of obtaining Side A DIC coverage, companies may purchase a less expensive stand-alone Side A “excess” coverage that simply adds more coverage to the primary A-B-C insurance tower, usually on the same terms as the primary A policy.  This “follow-the-form” type excess policy is generally seen as less attractive than Side A DIC coverage, as the excess policy primarily addresses coverage limits, not coverage gaps, in the primary A policy. 

• IDL Insurance.  Increasing in popularity, independent directors insurance may be purchased to give independent directors their own source of D&O insurance outside of the general A-B-C insurance tower.  Essentially, IDL insurance is a type of Side A DIC coverage. For independent directors, IDL ensures coverage that is not subject to dilution by claims against the company, management or interested directors, who may have a higher incidence of claims.  

• Tail Coverage. D&O insurance policies often have some type of coverage for claims regarding conduct that occurred during the insurance policy but for which the claim is made after the termination of the policy.  This “tail” coverage is especially important in change of control/sale transactions, where exiting directors and officers may still face claims for years after the exit event.  Most companies negotiate for a “tail” or “runoff” period long enough to cover any expected statute of limitations for such claims, and six years is the common duration for a tail policy. 

• Subsidiary Boards.  A parent or holding company may request that one or more of their directors serve on the board of directors of a subsidiary company, for example in the private equity/portfolio company setting, and some insurance policies treat such situations as covered under the parent company policy.  Companies should review how their D&O policy applies to such subsidiary directors, and consider having the subsidiary company have its own D&O policy (and its own coverage limits), so that this applies before the parent/holding company policy applies.

• Coverage for Investigations. Companies may be subject to informal investigations that requires production of documents and making personnel (including director and officers) available for interviews as witnesses.  These investigations can incur significant costs, including attorneys’ fees.  Attention should be paid as to whether and how defense costs related to informal and formal investigations are covered, for example how “claim” is defined. 

• Carvebacks to the Insured vs. Insured Exclusion.   To avoid collusive claims, most D&O insurance policies exclude coverage for so-called “insured vs insured” claims, where one party is making a claim against another party and they are both covered under the same insurance policy. Examples of such claims may occur, for example, in insolvency or where there is a dispute between independent directors and management.  The application of the insured vs insured exclusion is sometimes litigated, and more frequently contested, in coverage situations.  Particular attention should be paid as to how the insured vs. insured provision is drafted, especially the definition of who is considered an “insured” party.  Companies may be able to negotiate for “carvebacks” (exceptions to the exclusion, so that carvebacks are covered claims) such as:

• Derivative Claims.  This common carveback will allow shareholder derivative claims to be insured so long as certain basic conditions are met, such as the claim is not brought or assisted by a current director or officer of the insured company.  

• Former Director/Officer Claims.  Allowing claims brought by former directors or officers so long as they are brought in limited situations, for example as a shareholder (i.e., the fact that a shareholder is a former director or officer should not exclude the claim) or after a post-separation cooling off period (such as 1 or 2 years).

• Cross-Claims.  This carveback provides insurance coverage for cross-claims that occur on claims otherwise covered by the D&O insurance policy.  For example, an insurable claim may be made against an officer or director for something that another officer or director has or shares culpability, and so a carveback may be drafted to allow the claim to “correctly” proceed against the culpable party or parties while covering the defense costs of the wrongly named party.  

• Successors-in-Interest.  In insolvency and bankruptcy situations, it is possible that a creditor committee, receiver, bankruptcy trustee, debtor-in-possession or the like will bring an action against directors and/or officers.  On its face, as the claim is brought by a successor-in-interest to the company, this would involve an insured vs insured situation. A well-drafted carveback to allow for insurance coverage in such claims can address this problem.

• Employee Claims. Some D&O insurance policies provide a carveback for employment practices claims brought by an employee or former employee against an insured person such as an officer or director.  While the added coverage offered by this carveback can be beneficial, consider whether such claims are better covered under a separate employment practices insurance coverage, so that payment of employment claims doesn’t diminish the amount of coverage available under the D&O policy.

• Priority of Payment.  Some companies use a “priority of payments” provision in their A-B-C primary insurance tower to address the dilution issues, so that the Side A claims are given priority over Side B and Side C claims.  Carefully drafted, a priority of payments provision may also help directors and officers to obtain payment of Side A coverage in insolvency situations, as a bankruptcy court may determine that such coverage is not “shared” with the debtor estate.  It is generally considered, however, that stand-alone Side A DIC coverage is more favorable in such situations.

• Final Adjudication Requirements.  Like exculpation and indemnification, D&O insurance does not apply where a director or officer has engaged in disqualifying misconduct, such as fraud, willful violations of law and criminal behavior. Further, policies may exclude coverage for exemplary and punitive damages and fines in otherwise covered claims.  To prevent an insurance carrier from initially denying coverage because it unilaterally characterizes a claim as involving disqualifying conduct or circumstances, companies may well consider negotiating a “final adjudication” requirement for these disqualifications.  In this way, a policy may be drafted to require the insurer to pay defense costs up until the final judicial determination that the disqualifying conditions exist or that the exemplary and punitive damages and fines indeed apply.  More broadly, it may be possible to have such damages and fines included as covered claims (at least to the extent permitted by applicable law). 

• Severability of Wrongdoing.  An insurance carrier may deny coverage where a director or officer has engaged in disqualifying misconduct, as discussed above.  Companies may negotiate a severability provision so that the directors and officers who are not guilty of such misconduct maintain their rights to coverage.

• Triggering Side A Coverage. Particular focus should be given to how Side A coverage is triggered. Some policies provide that Side A is not triggered so long as indemnity is allowed or required even though it hasn’t yet been paid.  It may be possible to negotiate for a better Side A trigger---i.e., that Side A applies for claims unless the company has already paid indemnity.  In bankruptcy, for example, an indemnity payment from the company may be delayed (or not forthcoming) and thus impede a Side A recovery. 

• Financial Impairment Clause. Similar to the Side A trigger issue discussed above, it may be difficult (in insolvency especially) to trigger coverage where retention (deductible) payments apply-- if the company is unable to pay the retention amount the payments on the underlying policy may never kick in.  Having a “financial impairment” provision in the D&O policy can be used to eliminate the retention amounts and related issues in such situations.

• Understanding the Claims Process.    Among different insurance carriers, language in the policy may significant differ as to what constitutes a “claim” and when and how a claim should be “noticed” to the insurance carrier.  Single anchor policies—requiring that the claim (but not the notice of the claim) be made in the policy period are seen as being preferable. Some policies broadly define “claim” to mean not only a written demand for money damages or other action (such as filing of a lawsuit) but also the commencement of regulatory investigations or proceedings and situations involving less formal and more nuanced notice of potential problems. To enable coverage, policies provide that the company must notify the carrier of any “claims” promptly.  Companies, directors and officers can experience frustration with obtaining insurance coverage, or denial of coverage altogether, when the procedural formalities of timely providing notice of a claim to the insurance carrier are not strictly satisfied.  Before notifying the carrier of a claim, however, the company may wish to consult with legal counsel, as communication with the insurance carrier is not protected by attorney-client privilege and may be discoverable in litigation. 

• Conduct of the Defense. D&O insurance policies vary as to how defense of a claim is handled.  Insurance carriers commonly have a list (“panel”) of accepted legal counsel and associated billing rates and guidelines, which should be reviewed by the company.  Some issues that may be negotiated include whether the carrier’s consent is required to settle a claim and whether payment of defense costs may be clawed back where indemnification is denied.  Provisions regarding arbitration and mediation should also be examined for acceptability. 

Conclusion. There are many issues and potential solutions to consider in assessing whether a D&O insurance policy gives an appropriate level of personal liability protection to directors and officers.  Companies may select and negotiate insurance policies and provisions to give needed insurance coverage, while weighing the premium cost and likelihood and severity of potential claims.  Each situation is different.  It is prudent to analyze existing insurance policies and negotiate for additional protections before a claim or crisis is at the door or the company is nearing the zone of insolvency, as this preserves both the integrity of the process and the bargaining position with counterparties such as the D&O insurance carrier.

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