Originally Published on Law360 - January 10, 2014.
Directors and officers policies is the most important insurance to protect directors and officers from personal liability. Corporations often broadly indemnify their directors and officers so gaps in D&O insurance will have no impact until the company fails. At that point, it is too late to repair deficiencies in the D&O insurance program. Directors and officers should evaluate D&O insurance the same way they evaluate their compensation packages.
Lawsuits arising out of hundreds of bank failures — as well as other corporate failures — across the country have highlighted strengths and weaknesses in existing D&O programs. Some of the lessons learned are the following:
Policy Limits are Often Not Adequate
The collapse of a corporation can spawn multiple lawsuits which can consume a large portion of the available limits even if few of the suits go to trial.1
Carriers and brokers often suggest benchmarking a company's purchase of D&O insurance by comparing it to that of other companies. However, this approach may not take into account the real purpose of adequate policy limits. From the point of view of the director or officer, the D&O limits should be more attractive to a plaintiff than the director's or officer's own personal net worth even after a vigorous defense has exhausted a large portion of those limits.
The relatively low limits of D&O insurance programs are exacerbated by some of the features of how the program operates. The events which trigger coverage under the policy can be defined broadly and a defense can be available for investigations well before litigation begins. Insurers often market the broad scope of coverage provided by the D&O policies to demonstrate that the policies do a good job of providing a high-quality defense.
Perhaps for this reason, insurers for D&O policies accept very high rates — often as much as three to four times the rates that would be accepted under other corporate insurance programs — for defense counsel.2 The higher rates accepted for D&O defense and the possibility of multiple lawsuits arising out of the same "interrelated wrongful acts" being assigned to a single policy year create a significant risk that corporate problems will lead to rapid erosion of D&O policy limits.3
A second problem with D&O policy limits is the sharing of limits among insureds who have conflicting interests. First, in the event of a corporate bankruptcy, the directors and officers may be in conflict with the corporation. The bankruptcy trustee will argue that the D&O policies are property of the bankruptcy estate and may seek to terminate coverage or sell back the policies to the insurers to augment the estate. D&O coverage is commonly divided into Side A, Side B and Side C coverage. Directors and officers obtain the best possible coverage from Side A which provides no protection to the company itself. Separate freestanding "Side A Only" policies are arguably not subject to the jurisdiction of the bankruptcy court at all since the company itself has no ownership interest in them. Directors and officers should insist on significant freestanding Side A Only coverage if available.
Directors and officers can also run into trouble when sharing limits with each other. If directors become enmeshed in litigation, it may be that inside directors are substantially more culpable than the outside directors and failed to properly inform the outside directors. If the directors and officers share limits they will often be pressured to share counsel as well. Such joint representation can present serious conflicts of interest. It is awkward for counsel representing both officers and outside directors to give full attention to all of the defenses that might otherwise be available to the outside directors.4
Conflicts can emerge having insiders jointly represented as well. In cases involving bank failures, production officers charged with originating new business are sometimes represented by the same counsel who represent credit officers who are supposed to be guarding the bank's financial safety. Similarly, the chief executive officer and chief financial officer may be jointly represented even though the latter is supposed to honestly report financial performance of the company that in turn affects the compensation of the former. In each of these cases, joint representation may prevent the full development of one party's defense. At a minimum, conflict waivers are necessary. Waiving conflicts may be undesirable for the substantive defense but may be the only way to protect the D&O program against excessive defense costs.
For some D&O coverage plans, the problems with insufficient limits are exacerbated by other types of coverages being in the D&O policy.5 If it were possible to do so, a cautious outside director should demand his or her freestanding Side A Only D&O policy in limits sufficient to address his or her personal situation. If limits must be shared, they should be shared only with others who have a common interest — such as other outside directors. Even within the group of outside directors those on particular subcommittees (e.g. audit) may have greater exposure. In sum, the less a director or officer shares D&O policy limits with others, the better.
The Scope of Coverage Under the D&O Program May be Insufficient
D&O policies are structured in a fundamentally different way from commercial general liability policies. CGL policies are "occurrence based" and are triggered by damage that happens during the policy term regardless of when the claim was made and when a suit was filed. A significant weakness in all D&O insurance programs is that they are triggered only when there has been a "claim" during the policy period or in some cases a "circumstance."
The policy definitions of "claim" and "circumstance" and the timing requirements as to when they must be reported to trigger coverage under the D&O policy are extremely important. If the policy defines "claim" to include only written demands and does not allow the reporting of a "circumstance," both the insured and the insurer may learn of a situation which everyone knows ultimately will lead to a claim but which the insured cannot report so as to trigger coverage during the current policy term and which will be excluded during subsequent policy terms. This potential coverage gap can be minimized, but not entirely eliminated, by careful attention to the definition of "claim," "circumstance," and to the timing of the reporting obligations in the policy.
Once a D&O policy is triggered, the insured must demonstrate that the claim involves the types of exposures that fall within the basic coverage grant of the policy. Typically a "claim" for a "wrongful act" leading to "loss" or "claims expense" will trigger coverage. Some policies contain definitions of "claim" which include investigatory proceedings broaden the scope of coverage that would otherwise be provided and may provide a defense even where the indemnity obligation is limited.
Some D&O policies define "loss" to include "claims expenses." Arguably this means that "claims expenses" (defense costs) will be covered only if a covered loss is proven and only to the extent of the covered loss. As a result, some policies allow the insurer to allocate between covered and uncovered claims and to claw back defense payments that are advanced and that eventually prove to relate to claims that are later shown not to be covered. Such provisions can lead to conflicts not only between the insured and the insurance carrier but also among insureds competing for a limited amount of insurance.
Some D&O policy programs are structured to provide separate payments for "claims expenses" and "loss." Under such policies, once there is a "claim" arising out of a "wrongful act," the "claims expenses" of defending the claim are covered regardless of whether the claim itself leads to a covered "loss." These policies are more like CGL policies which provide that the insurance carriers have a duty to defend a claim even if there is only a potential for coverage and even if the claim ultimately ends up being not covered. Nonetheless, there may still be allocation of defense costs between covered and uncover claims.
The Ninth Circuit has held that D&O insurers have a duty to advance defense costs even though they may not have a duty to defend.6 If the insurers cannot demonstrate that all or a specifically identifiable portion of the loss is unquestionably uncovered at the time defense costs are incurred, they may incur those costs and have little practical ability to claw back the funds that have been spent. However, since only covered "loss" reduces the policy limits under many D&O programs, the advancement of defense costs for claims that prove not to be covered may not reduce the policy limits available for the resolution of other claims. No doubt D&O insurers will argue that once they have paid anything, those payments exhaust the remaining available limits. However, policyholders should not assume this is automatically the case.7
A third area that affects the scope of coverage available under D&O insurance is exclusions. These exclusions can be couched as part of the coverage grant. For example, some banks were issued policies that defined "loss" to exclude losses on loans. Read literally, this language could be interpreted to make the D&O coverage sold to banks illusory since essentially all of the business of most banks arises out of loans.8 Insurers will put forth a panoply of exclusions designed on the one hand to try to narrow coverage as much as possible, but also to allow those marketing the policies to assert that the coverage remains broad. All of the insurer's policy exclusions should be reviewed carefully with a jaundiced eye for the impact they may have.
Another way in which the scope of coverage may be limited under D&O policies is through a "retroactive date" which limits or eliminates coverage for "prior acts." Even if a claim arises out of facts which occurred years prior to the policy, the claim still triggers the policy if it is made and timely reported during the policy term, unless there is a limitation on "prior acts" coverage. Such limitations are always a red flag particularly for a new or outside director who does not have knowledge of the company's history.
Protection Against Bad Actors May Not be Adequate
Misconduct by a director or officer or an inaccurate statement on an application — even an honest misstatement — may allow the insurer to rescind the policy. Insurers frequently use postclaim underwriting to aggressively pursue rescission in other lines of insurance and would do so with D&O insurance if the policies did not frequently contain provisions protecting against just such actions.
In D&O insurance, it is common to have severability provisions such that the misconduct and/or misstatements of individuals vitiate coverage only as to those particular individuals or perhaps as to those individuals and to the company but not as to others insured by the policy. Specifically, directors and officers insured under a freestanding Side A Only policy should justifiably expect that their coverage should be impacted only by their own particular misconduct.
Also, to the extent that insurance can be denied because of the fraudulent conduct of an insured, it is common for the policy to require that that fraud must be determined by a "final adjudication" of a court. To avoid the risk that the suit against the insured could be settled without such an adjudication, but that the insurer could seek a separate adjudication in a declaratory relief action, it is best to seek language that protects the insured unless fraud is established by a final adjudication against that particular insured in the precise case where the D&O coverage is being sought. Also, since many different claims against a director or officer will include accusations of misconduct for personal profit, any exclusions for misconduct based upon seeking personal profit should be as narrowly circumscribed as possible, and if possible, be triggered only by a final judgment to that effect.
1 For example, the failure of IndyMac Bank FSB spawned over a dozen lawsuits, only one of which went to trial, resulting in over $65 million out of $80 million in policy limits being consumed – mostly by defense costs – in only a few years. The failure of Adelphia Corporation implicated at least $60 million in directors' and officers' insurance and yet a number of directors were left fighting battles with bankruptcy trustees to obtain the defense cost reimbursements initially limited to $300,000 per director.
2 Although defense cost reimbursement in Southern California is often limited to hourly rates below $300 on commercial general liability insurance policies, the author has seen defense costs under D&O policies reimbursed at rates of up to $800 per hour.
3 Most CGL insurance programs have defense "outside of limits" such that the limits remain available to pay a judgment or defense even after hard fought litigation. It is rare for D&O policies to have either defense outside of limits or even a separate defense limit. It is appropriate that D&O policies are often described as "wasting," "self-consuming," or "vanishing."
4 Inside directors and others may have a more immediate conflicting interest as well. In the failure of Tyco Corporation, the insurers sought to disclaim any responsibility to defend Tyco's CEO Kozlowski and other insiders but at the same time acknowledged their willingness to defend other insureds. See Federal Ins. Co. v. Kozlowski (N.Y. App. Div. 2005) 18 A.D. 3d 33. If the D&O insurance contains severability clauses allowing the insurer to deny coverage for wrongdoing only to the particular directors and officers who are culpable in the wrongdoing, some insureds may have an interest in other insureds being denied coverage to protect limited policy proceeds.
5 For example, employment practices liability (EPLI) and fiduciary liability insurance are sometimes combined with D&O policies. These coverages primarily protect only the company itself or a limited subset of the directors and officers.
6 In Gon v. First State Ins. Co. (9th Cir. 1989) 871 F.2d 863, the court held that D&O policies required advancement of defense costs as they were incurred without allocation between covered and uncovered costs where such allocation was not practicable. The court found a duty to pay defense costs as incurred even though the policy contained no duty to defend. See also Okada v. MGIC (9th Cir. 1986) 823 F.2d 276. The Okada court found that the inclusion of "claims expenses" in the policy definition of "loss" required the insurer to pay defense costs as they were incurred.
7 Insurers may advance defense costs reserving their rights and even requiring insureds to enter into reimbursement agreements to repay defense costs advanced for claims found not to be covered "loss" under the policy. Such agreements can work to the advantage of some insureds, such as outside directors, who are typically less vulnerable to the exclusions that give rise to reservations of rights.
8 At least some underwriting history suggests that at least some insurers provided this definition simply to avoid any argument that D&O coverage extended to everyday losses on loans so as to make the insurer the guarantor of all of the bank's loans. In contrast, the D&O program was still intended to protect directors and officers from claims of negligence even if that negligence resulted in losses on loans that, for example, should not have been made because they did not satisfy the bank's underwriting rules.