ALTHOUGH A MULTITUDE OF LIABILITY INSURANCE genres exist in today’s marketplace, Directors and Officers Liability Insurance (“D&O”) remains one of the least understood. A review of several common features of D&O may help explain its structure and provide a better understanding of its scope, purpose and coverage.
A Brief History1
With the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934, Lloyds of London began offering coverage to individual directors and officers who could face potential liability under the new statutes. Directors and officers perceived little risk, so few of these policies were sold.
The advent of state statutes in the 1960’s and 1970’s permitting corporations to indemnify directors and officers against fiduciary and management liabilities brought D&O policies to the forefront of the corporate insurance market. Today, nearly 100% of public companies and between 75% and 80% of private companies purchase some form of D&O insurance.2
Standard Coverages
A classic D&O policy contains three distinct coverages:
Coverage A: Non-Indemnified Loss
Coverage B: Indemnified Loss; and
Coverage C: Company Coverage.
The first question to ask in any D&O analysis is whether the company is indemnifying or plans to indemnify the director or officer at issue. State statutes, corporate charters and bylaws, and even employment agreements, normally contain extremely broad indemnity authorizations, generally stating that a company is required or permitted to indemnify an officer or director (and in some cases an employee) as long as the individual acted in good faith and unless that individual’s conduct was opposed to the company’s best interests.3 Some states also preclude indemnity for the individual target of a derivative action, and financial insolvency nearly always impairs or impedes indemnity. Other than those circumstances, directors and officers should enjoy indemnity for most alleged wrongful acts that occur in their capacity as members of the board.
Coverage A
In the limited circumstances in which a director or officer seeks D&O coverage for a claim or lawsuit in which the company has declined indemnity or cannot indemnify because of financial insolvency, Coverage A provides the insurance for this non-indemnified loss. Coverage A, also called “Side A” insurance, differs from the other coverage parts in several important ways. First, there is rarely a deductible or self-insured retention (“SIR”) — the coverage usually applies from first dollar. This makes sense because an unindemnified director or officer otherwise could suffer substantial financial hardship if he or she had to expend significant personal funds to pay a deductible or SIR to trigger coverage.
Second, Coverage A normally cannot be cancelled except for non-payment of premium and it cannot be rescinded for any reason, even if there were misrepresentations in the application. Finally, many policies contain a Side A “carve-back” for exclusions that otherwise apply. In other words, a D&O policy might contain a pollution exclusion, but the exclusion would not apply to a claim under Coverage A when the director is not indemnified. To better protect individual directors and officers when indemnity is not forthcoming, Coverage A routinely provides broader and more comprehensive coverage than any of the other coverage parts.
Coverage B
If a director or officer seeks indemnification from the company and the company grants the request, Coverage B applies. Coverage B reimburses the company for covered amounts that it has paid the directors or officers as indemnity. Because indemnification statutes, charters, bylaws and agreements generally provide broader indemnification than D&O policies, it is not uncommon for a company to indemnify the directors and officers for 100% of the defense expenses and loss they have sustained, but recover a smaller percentage from a D&O insurer because of exclusions, other limitations on coverage, and payment of a deductible or SIR.
Coverage C
For years, D&O policies only contained Coverages A and B. Company coverage, or “Coverage C” did not exist.4 In 1995, however, the Ninth Circuit decided Nordstrom, Inc. v. Chubb and Son, Inc.,5 which addressed the issue of how a court should allocate settlement payments and defense costs between the directors and officers and the company when both are co-defendants in a securities lawsuit. The Chubb policy issued in Nordstrom did not contain an allocation clause and there was no company coverage. Despite the lack of an allocation clause, Chubb argued that it should not have to pay the entire settlement when Nordstrom was not covered. Nordstrom, on the other hand, argued that it was “legally obligated” to pay the full settlement, on behalf of itself and its officers and directors, so Chubb should reimburse it in accordance with the express language of the insuring agreement. Finding Nordstrom’s liability completely concurrent with that of the directors and officers, the Ninth Circuit held Chubb liable for the entire settlement.6
In response to the holding in Nordstrom, several insurers became interested in offering Coverage C, which would permit coverage for companies who are sued along with their directors and officers.7 Modern D&O policies almost invariably contain some form of company coverage. For publicly held companies, Coverage C typically covers securities claims. Securities claims include claims alleging a violation of any federal, state, local or foreign securities statutes or claims brought by a security holder of the insured’s securities, among other things.8 In private company and nonprofit policies, Coverage C can be much broader, covering non-securities claims. Also, to avoid the situation in Nordstrom, insurers normally provide an allocation provision delineating how the coverage for defense expenses and settlements or judgments will be allocated among the various insureds.
Traps for the Unwary and How to Avoid Them
Most disputes regarding D&O insurance derive from three inter-related issues: terminology, timing or transition. These concepts are not limited to D&O policies, but it is essential to consider them in a D&O context to avoid unnecessary coverage denials.
Claims-Made
A typical D&O policy covers claims first made against the directors, officers or the company during the policy period. So, what constitutes a claim? The definition of “claim” may be surprising:
- A written demand for monetary damages or non-monetary relief;
- A civil proceeding commenced by service of a complaint or similar pleading;
- A criminal proceeding commenced by a filing of charges;
- A formal administrative or regulatory proceeding commenced by a filing of charges, formal investigative order, service of summons or similar documents;
- An arbitration, mediation or other alternative dispute resolution (“ADR”) proceeding;
- The service of a subpoena if served upon an insured person pursuant to a formal administrative or regulatory proceeding;
- Awrittenrequesttotollorwaiveastatuteoflimitations;9 or
- An official request for extradition.10
Problems arise because insureds receive letters, subpoenas, demands for ADR or requests to toll statutes of limitations and they do not recognize these communications as “claims” that need to be reported to a D&O insurer. All too frequently insureds report a lawsuit, but face a coverage denial because the demand letter preceding the lawsuit came during a prior policy period that has since expired. If the “claim” was not first made during the current policy period, a D&O insurer likely will deny coverage. To avoid this situation, insureds should scrutinize all demand letters to determine if the claimant seeks money, services, ADR, a tolling agreement, extradition or any other action that could constitute a “claim.” If in doubt, report!
Reporting Claims
Many D&O policies now mandate that notice be given to the insurer within the policy period or shortly after the policy expires. These policies are termed “claims-made and reported” to describe this notice requirement. In addition to recognizing claims, it is important to provide prompt notice of all claims to avoid a coverage denial based on late notice. Also, although it is common for insureds to ask their insurance broker or agent to handle the notice, better practice compels insureds (or their coverage counsel) to prepare and send the notice themselves, exactly in accordance with the policy terms.
Notice of Circumstances
Most D&O policies also contain a provision that permits insureds to report an act, event, demand or circumstance to the insurer, even if it does not yet meet the definition of “claim.” Sometimes insureds do not know or cannot tell if a demand letter or other request constitutes a claim. Instead of waiting to see if the potential dispute matures into a lawsuit, it may be prudent to send the demand or request to the insurer with whatever details the policy requires to effectuate a notice of circumstances. Then, if the matter becomes a claim at a later date, coverage is triggered or “parked” in the policy period in which the notice of circumstances was given. Thus, a notice of circumstances, if properly given, avoids the problem of late notice. Some insurers strictly construe the requirements for notices of circumstances; therefore, it is imperative to read the policy carefully and provide exactly the information the policy requires.
Tender of the Defense
Some D&O policies provide a duty to defend and some policies do not. Other policies contain an option for the insured to tender the defense to the insurer within a specific amount of time. The time for a tender of defense varies dramatically — from as little as 10 days to as much as 60 days. Although many insureds would prefer to control their own defense and have no desire for the insurer to defend, others recognize that choosing the duty to defend option or tendering the defense can provide certain advantages. For example, in a duty to defend context, most D&O policies do not apply any allocation reduction to the defense costs. In other words, if the insurer is defending, 100% of the defense costs are covered, even the defense costs for non-covered claims. Sometimes, the defense costs are subject to repayment in the event non-coverage is established, but these provisions appear less frequently in a duty to defend policy.
Similarly, the vast majority of D&O policies state that payment of defense costs will erode the limit of liability. This concept is called “defense within limits.” If defense costs erode the limit of liability, it is possible for the defense of a covered lawsuit or claim to completely exhaust the policy limits and leave no money available for settlements or judgments. To avoid this situation, some modern D&O policies offer a dedicated limit of liability for defense costs, after which payment of additional defense costs will erode the limit of liability.
Common Exclusions
Insurers issue D&O policies primarily to cover individuals and companies for management liability, which includes negligence, misrepresentation, and breach of fiduciary duty, among other things. Some common D&O exclusions pertain to liabilities that other types of insurance policies cover. For example, D&O policies routinely exclude bodily injuries, property damage, and personal and advertising injury (commercial general liability), ERISA (fiduciary liability), wrongful termination, harassment, retaliation and workplace torts (employment practices liability), worker’s compensation (worker’s compensation and employer’s liability), and infringement of patents, trademarks and copyrights (intellectual property liability). With various exceptions, D&O policies further preclude coverage for claims by one insured against another. Finally, D&O policies do not cover deliberate fraud, willful statutory violations and illegal personal profit or remuneration, except generally for defense costs.
Professional liability exclusions, also commonly found in D&O policies, provide a unique challenge to coverage. A typical professional liability exclusion states: “The [insurer] shall not be liable for Loss on account of any Claim . . . based upon, arising out of or in consequence of . . . the rendering or failure to render Professional Services by an Insured.”11 “Professional Services” is defined as “services which are performed for others for a fee.”12 Many times it is difficult to distinguish D&O claims from ordinary business transactions because they involve the same subject matter (the insured’s business or finances) and actions by the officers and employees. An insured can address this dilemma by purchasing both D&O and professional liability insurance. Dozens of mainstream insurers offer policies that contain both coverage parts in a single policy, which reduces finger-pointing in the event that a claim potentially triggers either coverage.
Switching Insurers
Except in limited circumstances, a D&O insurer assuming the risk from another carrier will not accept any coverage for wrongful acts that took place before the new insurer came on the risk. To counter this lack of coverage for prior acts, most D&O policies offer options to purchase an extended reporting period (“ERP”), commonly called a “tail,” should the insurer or insured terminate or non-renew the policy. An ERP provides the insured with additional time within which to report claims that are made after the policy expires, but arise out of wrongful acts that are alleged to have occurred before the policy termination. A similar situation occurs if the insured experiences a change in control or a “transaction,” which normally means a takeover in which the insured is not the surviving entity or another entity obtains more than 50% control of the insured.13 In these circumstances, the insured will experience a gap in coverage if it does not purchase a tail. As discussed above, another way to solve this problem is to give the outgoing insurer a valid notice of circumstances. A notice of circumstances only applies to known acts, events or circumstances, however; an ERP is broader because it potentially covers claims about which the insured has no knowledge prior to the transaction or policy termination.
Conclusion
D&O policies are as varied and complex as the companies and individuals they insure. This brief primer only skims the surface of some of the more interesting insuring agreements, definitions, exclusions and conditions that combine to create this coverage. Particularly with new cutting-edge policies that expand traditional coverages and find innovative ways to reduce limitations, the review and analysis of a D&O policy can scramble the brain. For insureds faced with D&O issues, the best advice is to get help! A coverage lawyer or insurance professional can assist the insured with navigating the complicated provisions and making the best insurance decisions to maximize coverage.
© The Advocate 2016
Reprinted with permission.
This article first appeared in The Advocate, Vol. 75, Summer 2016.
