Issues To Consider When Buying D&O Liability Insurance

Abstracted from: The Continuing Crisis In D&O Insurance:

How Can Directors And Officers Be Sure Their Personal Assets Are Protected?

By: William Cotter National Union Fire Insurance Company of Pittsburgh, PA

D&O Advisor - Vol. 1, No. 2, Pgs. 48-55

Overview:

Describes the risk factors affecting the availability and adequacy of D&O liability insurance, and considers the impact of recent court decisions. Addresses pension fund issues, suits brought against smaller companies, and ambiguities in Sarbanes-Oxley.

Scandals make for bad law, higher liability risk.


Recent court decisions, many arising out of the major corporate governance scandals of the last few years, may lower the risk bar for corporate officers, directors, and their insurers. The standard of required scienter may fall as well. One court’s holding that private companies’ directors owe the same fiduciary duties as public directors will also encourage suits. William Cotter warns D&O insurance carriers to take heed of the implications. For example, corporate indemnification is generally not available in derivative actions. In fact, the SEC has suggested that indemnification undermines the punitive impact of a settlement with an individual defendant. It may begin to condition its settlements on the defendant agreeing to forgo corporate indemnification of the cost. If directors cannot rely on indemnification, they must look to their D&O insurance coverage.

Targeting smaller companies.

Another risk factor likely to impact D&O insurance, according to the author, is the probability that the plaintiffs’ bar will go after smaller companies in the future. Restated financial statements frequently indicate a problem that results in securities litigation. Almost half of the recent restatements have been made by companies with less than $100 million in revenue. Because these smaller companies generally have fewer shareholders, plaintiffs are better able to control the litigation and to push for quick settlements. Some smaller companies may also find prohibitive the cost of complying with all the new requirements under the Sarbanes-Oxley Act of 2002. Thus, a small company’s litigation defenses may be weaker. The lesson for insurers? They may be underpricing the cost of D&O insurance for these riskier companies.

Pension fund issues.

Directors and officers may face increased liability arising from the company’s pension fund. If a 401(k) plan offers the company’s stock and if corporate fraud is discovered, plaintiffs may claim that the fiduciaries should have divested the plan of the company stock. For this purpose, fiduciaries may include both plan fiduciaries and other directors and officers of the company. The author also notes that some defined benefit plans are underfunded. Because of the earlier strong investment climate, firms underestimated the amount that needed to be invested. To compensate, companies must now make significant additional contributions to these funds, causing a charge to earnings. Lawsuits may also allege that the company’s prior earnings were inflated because the defined benefit plans were underfunded.

Sarbanes-Oxley’s impact on insurance costs.

Over the next few years, Sarbanes-Oxley is likely to increase the risk to officers and directors, and therefore to D&O insurers, cautions the author. Adequate D&O insurance is necessary so that directors feel confident even when making risky-but-innovative decisions for their companies. The new statute and the regulations are ambiguous and require clarification in many areas. Plaintiffs’ attorneys will use those ambiguities to bring suits seeking favorable interpretations of the law, and insureds will call on their D&O policies for defense costs. Some companies may not focus on good governance practices, assuming that their governance practices are appropriate because the practices comply with Sarbanes-Oxley or because the directors are independent, yet history has proven that D&O insurers should not be so complacent.

Abstracted from D&O Advisor, published by American Lawyer Media, 345 Park Avenue South, New York, NY 10010

Review D&O Liability Insurance Before Bankruptcy To Ensure Its Adequacy

Abstracted from: Director/Officer Liability In Event Of Bankruptcy: Can You Count On Your D&O Policy?

By: David Sunkin and Kirk Pasich Earl Scheib Inc., Sherman Oaks, CA (DS); Pasich & Kornfeld, Los Angeles, CA (KP)
ACC Docket - Vol. 21, No. 10, Pgs. 114-130

Overview:

Outlines what types of D&O coverage are available, and analyzes how the insured company’s bankruptcy affects coverage. Suggests ways to maintain coverage in the wake of a bankruptcy.

Relying on D&O insurance.

In the event of a company’s bankruptcy, the automatic-stay provision of the Bankruptcy Code protects the company from lawsuits, but actions against the directors and officers are not stayed. They must therefore rely on their D&O insurance. David Sunkin and Kirk Pasich explain how corporate bankruptcy affects the coverage. Directors’ and officers’ liability insurance generally provides coverage for the directors and officers but also for the company if it must indemnify those individuals. The D&O portion of the policy usually requires the insurer to cover all losses resulting from wrongful acts for which the directors and officers are not indemnified, while the company portion covers losses incurred by the company as a result of its obligation to indemnify. Losses generally include damages, judgments, settlements, and legal defense costs. D&O policies may also be written with entity coverage, which would cover losses the company faces as a result of securities litigation or employment practice claims.

Policy’s fate during bankruptcy.

Courts have generally held that the insurance policy itself is the property of the bankrupt’s estate but that the proceeds are not. However, if the policy provides coverage for the debtor as well as the directors and officers and if it is subject to an aggregate limit, the value of the policy to the debtor will be diminished if the directors’ and officers’ claims are paid. This, the authors point out, would effectively violate the automatic stay. Deductibles and self-insured retentions ("SIRs") may also give rise to coverage issues. Insurers have argued that, when multiple policies are in place, the SIRs and deductibles must be paid on all the policies before the insurance proceeds from any one policy are due. Courts have rejected that argument, distinguishing the usual rule of horizontal exhaustion (which requires exhaustion of all primary policies) by noting that SIRs and deductibles are not primary insurance but contractual terms. The policy may explicitly require that the debtor pay the deductible or SIR from its own funds, but for a bankrupt company, this can be an insurmountable hurdle. At least one court has held that the debtor can satisfy the SIR requirements of one insurance policy by using the proceeds from another.
Common defenses. When the claim against the insureds alleges fraud, the insurer may attempt to rescind the policy, arguing that the application failed to disclose the fraud. This argument is gaining steam, note the authors, in the light of the notorious corporate accounting scandals of the last few years. The insured will argue that its knowledge of a potential risk does not mean that it purposely made a material misstatement in its application. At least one court has agreed that fearing a potential lawsuit, while troubling with the benefit of hindsight, is not material misrepresentation. Another area of conflict arises because D&O policies generally exclude coverage for insured-versus-insured lawsuits. In bankruptcy cases, the trustee often brings a claim against the former directors and officers. Some courts have held that the trustees’ claims are made on behalf of the estate and not the company, so the insured-versus-insured exclusion is inapplicable.

Practical steps.


The authors suggest several steps that corporate counsel can take to ensure D&O coverage remains despite the company’s declaration of bankruptcy. Review all D&O policies to evaluate the level of coverage and to make sure that the policy requirements are being met. Insurers attempt to exclude coverage of claims resulting from fraudulent financial statements; however, under most policies, coverage will be provided if the insured gives adequate notice of the potential claim. If possible, purchase separate policies, one for entity coverage and the other for directors’ and officers’ liability. When double polices are not practical, the sole policy should have separate limits for the entity insurance and the D&O coverage. Negotiate the terms to ensure that bankruptcy will not be a termination event and to include a waiver of the automatic stay.

Abstracted from ACC Docket, published by Association of Corporate Counsel, 1025 Connecticut Ave. NW, Suite 200, Washington, DC 20036-5425.

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