• Current Issues in Directors and Officers Insurance
  • October 14, 2004 | Author: J. Chase Cole
  • Law Firm: Waller Lansden Dortch & Davis, LLP - Nashville Office
  • Buyers of directors and officers liability insurance face a rapidly changing landscape. Throughout the 1990's, rates and deductibles declined, in response to competition among insurers and the belief that the Private Securities Litigation Reform Act of 1995 would lead to an era of decreased liability. Now, because of corporate scandal, the largest bankruptcies in history and strict new regulations prompted by the Sarbanes-Oxley Act, all that has changed. In addition, Delaware courts are focusing closely on the duty of good faith with the effect of expanding personal liability of directors.

    In 2003, average premiums increased 33% (and, in some industries, between 100% and 500%, according to AIG, the nation's largest D&O insurer), combined with increased deductibles, and strict new policy terms. While evidence suggests that the market is softening in 2004 as new insurers enter the D&O market, attention to the policy provisions and the process of selecting an insurer is still important. Below are a few of the critical issues to consider in the process of selecting a D&O policy.

    Severability and Rescission A severability provision allows an innocent director or officer to retain insurance coverage despite the fraud or wrongdoing of another insured. Most D&O policies are rescindable by the insurer in the event of fraud or misrepresentation, especially fraud or misrepresentation in the application. Severability restricts the rescission to those with knowledge of the fraud, leaving other directors and officers with coverage - essentially treating each director and officer as individually insured. Full severability is increasingly unavailable. Many insurers that once provided severability are seeking the right to rescind the entire policy.

    In Cutter & Buck v. Genesis Insurance Co., a federal district court allowed the insurer to rescind the company's D&O policy because the application, signed by the CFO, included financial statements found to be intentionally misleading. Despite the fact that most directors and officers had no knowledge of the fraud, the policy contained a provision that imputed the knowledge of the signer to all directors and officers. As a result, the company had no D&O coverage for a securities class action lawsuit.

    In some states, most notably California, any material misrepresentation in an application is grounds for rescission, even if not intentional. A multi-year term, a renewal without a new application, or an application that includes no financial statements (all are rare in the present environment) may be an inexpensive way to remove possible grounds for rescission. Beware of policies that require affirmation of prior applications, which might allow rescission for the misrepresentations of prior directors and officers. Ideally, independent directors, those least likely to be responsible for misrepresentations, should negotiate for non-rescindable "Side A" policies (which would only take effect if the primary D&O coverage is rescinded).

    While it might be dangerous to sign policies that allow rescission for fraud allegations or indictments, an officer who admits fraud should be excluded from coverage immediately, and the company's bylaws should not allow indemnification. Many courts have held that a company must pay for director and officer defense until final sentencing or final adjudication, unless the company's bylaws provide otherwise. In the year between his guilty plea and a final sentencing on May 26, former Rite Aid CFO Frank Bergonzi's legal bills were paid by the company. One officer, despite his admitted fraud, could exhaust the D&O policy limits, leaving nothing for suits against innocent directors. Similarly, in Federal Insurance Company v. Tyco International, Ltd., a New York trial court held that the D&O insurer could not rescind the policy without a court ruling, mandating that the insurer pay Dennis Kozlowski's defense charges until the court found the rescission valid.

    Entity Coverage Until a few years ago, many companies bought policies only to protect the personal assets of directors and officers, for situations when indemnification by the company was unavailable. Seeking additional coverage for the company, many companies subsequently signed on for "entity coverage". Unfortunately, this type of coverage had some unintended consequences. The company could exhaust the coverage limits of the policy, leaving nothing for the directors and officers. Moreover, if the company enters bankruptcy, some courts have held that the policy is a part of the bankruptcy estate, thus freezing payments to anyone except the company, including the directors. This area of law is in flux, but a clear "order of payments clause" may be a solution. Such a clause provides that any payments under the policy go first to the directors and officers, then to the company. Others suggest policy allocations, with specific amounts dedicated only to directors and officers.

    Scope of Coverage It is critical to know what categories of legal bills a D&O policy will cover. Often this is buried in the definition of "claim" or "loss", or it might be addressed in the exclusion section of the policy. Many policies do not cover pre-litigation expenses, investigations or regulatory actions (including those by the SEC), until they reach a court, and some policies exclude costs of appeals. Other policies specifically exclude suits arising from financial restatements or deny coverage for punitive damages (some states do not allow insurance coverage for punitive damages).

    Most policies contain an exclusion for losses that are "uninsurable under applicable law". This might exclude punitive damages, but under New York law, which governs many insurance policies, it also covers "disgorgement" and "restitution". In Vigilant Insurance v. Credit Suisse First Boston, the court held that amounts payable under an SEC consent action that used the term "disgorgement" were uninsurable, leaving CSFB to pay $70 million on its own. Because the Sarbanes-Oxley Act provides for reimbursement or disgorgement to the company in certain situations, these payments are likely outside the scope of many D&O policies. Similarly, some courts have held that damages under Sections 11 and 12 of the Securities Act of 1933 are restitutionary in nature.

    Legal Cost Matters Because the insurance company will be paying the bills, directors and officers will have to choose from the insurer's list of preferred counsel. Directors and officers should ask for and review this list and make sure they are comfortable with the choices. Insurance companies may add counsel at the request of a company, as long as no conflicts would result.

    Some D&O policies require the company to advance the funds for counsel and make reimbursement payments at the close of an action. Under the Sarbanes-Oxley Act, payments to counsel from companies for the legal costs of individual directors and officers may be considered a prohibited loan if made prior to final resolution of the case. Directors and officers should insist on a "pay as you go" clause from the insurer to avoid this problem.

    Claims Made or Occurrence Coverage Most D&O policies are written so that the policy only covers events for which claims are made during the policy term ("claims made" coverage). The alternative is an "occurrence" policy which offers coverage for any events that take place during the term of the policy - no matter when claims are brought. Occurrence coverage, because it offers more certainty, is usually more expensive. Claims made coverage raises the possibility that if the company is unable to find "tail" D&O insurance upon the expiration of a policy, it will have no coverage for prior acts. Similarly, combining the two types of policies could leave a substantial gap in coverage.

    Imagine that a company is covered under a claims made policy when it issues a financial restatement on December 29. A related lawsuit is filed on January 2, when the company is covered under a new occurrence policy. Both insurers will deny coverage, because the claim was not made during the term of the claims made policy, and the occurrence that led to the claim did not occur during the term of the occurrence policy. Companies should study their policies to ensure that there are no gaps in coverage.

    Carrier Issues It would be easy to assume that all D&O insurers are created equal, or at least are stable enough to protect insured parties, but, in 1999, the second largest D&O insurance carrier (Reliant) went bankrupt, despite having an A- rating just a few months before, leaving many directors and officers without insurance. In the present environment, with several significant fraud cases waiting in the litigation pipeline and many new insurers entering the market, it pays to investigate the stability of any prospective D&O carrier.